Friends,
You may have seen the news last week regarding the U.S. debt rating downgrade by Fitch, one of the top credit rating agencies around the world. A reason that Fitch gave for the downgrade – “expected fiscal deterioration” along with the expanding debt obligation shouldn’t be ignored. However, we tend to agree with the commentary below suggesting no material long-term impact on the markets. It’s good to note that the U.S. government’s debt rating of AA+ is still one of the top ratings, and we believe the US Treasury market will be the leader for essentially risk-free income.
SUMMARY
Fitch noted three primary reasons for the downgrade: growing budget deficits, a high and growing debt level and deteriorating governance (more detail below).
We don’t believe that this downgrade will have a material impact on markets beyond some potential near-term volatility.
- Each of the issues noted by Fitch has been brewing for decades. The growing budget deficit is indeed a challenge that the country must face, but it isn’t a new one and it certainly isn’t a surprise to markets.
- Previous episodes suggest that markets will look through the downgrade.
- The U.S. debt rating is the second highest that Fitch offers; only two U.S. companies – Microsoft and Johnson & Johnson – have a higher rating.
- The U.S. dollar remains the world’s reserve currency, as even Fitch noted, which gives the US government unparalleled flexibility to finance its spending.
The bigger risk for the government and the overall economy is much more simple: higher interest rates. As rates stay higher for longer, the Treasury must roll existing debt into higher cost debt, which then becomes a drain on the budget.
THE DETAILS
What prompted Fitch’s decision to downgrade the U.S.?
1. Growing budget deficits
The current U.S. government budget deficit is running at about 5.5% of GDP, a vast improvement over pandemic levels, but uncomfortably high. Moreover, based on current spending trajectories, that percentage is expected to continue growing.
Total Deficits, Primary Deficits, and Net Interest Outlays
Source: Congressional Budget Office, The Budget and Economic Outlook: 2023 to 2033. Data as of August 2, 2023.
2. A high and growing debt level
As interest rates stay higher for longer, the Treasury must roll existing debt into higher cost debt, which then becomes a drain on the budget. Public debt has ballooned relative to GDP over the last few decades, though up until recently the cost of servicing that debt has been at historic lows. Currently, interest on U.S. debt costs the government the equivalent of 1.9% of GDP every year. This is above the low of 1.2% in 2015, but well below the peak in 1991 of 3.2%. Assuming interest rates remain at current levels, those interest payments will continue to rise.
Source: Kestra Investment Management, Federal Reserve Bank of St. Louis with data from U.S. Office of Management and Budget. Data as of August 2, 2023.
3. Deteriorating governance
Fitch pointed to repeated standoffs related to the debt ceiling and the government’s lack of a “medium-term fiscal framework,” including the inability to address rising social security and Medicare costs, as well as recent tax cuts. The government’s challenge is that social security and Medicare spending is generally seen as sacrosanct and not to be changed. That leaves very little room for the government to adjust spending down. For instance, this year, discretionary spending is projected to be 27% of the budget. By contrast, in the 1960s, a full 67% of total federal spending went to discretionary programs.
Feel free to give us a call if you have any questions or concerns.
Matt and Andrew