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Raymond James CIO Larry Adam examines the reasons for the decision and what the impact may be to the financial markets.

To read the full article, see the Thoughts on the Market publication linked below.

On August 1, 2023, Fitch Ratings downgraded the U.S. sovereign credit rating by one notch from AAA to AA+. The move was not a complete surprise as Fitch placed the U.S. on watch for a possible downgrade during the debt ceiling negotiations, following Standard & Poor’s playbook when they downgraded the country’s AAA-credit to AA following the 2011 debt ceiling standoff.

Is the U.S. downgrade a significant event?

While media reports are suggesting the rating action is a nonevent, Fitch’s action is a serious reminder that U.S. fiscal dynamics are on an unsustainable trajectory – a trend we have been highlighting for some time now. While this action does not change our short-term views on the markets, the fiscal well-being of our nation remains on our long-term radar.

Fitch’s downgrade was based on four reasons:

• Erosion of governance | Fitch noted the government’s “steady deterioration in standards over the last 20 years” regarding fiscal and debt matters while specifically highlighting “the repeated debt-limit political standoffs and last-minute resolutions (that) have eroded confidence in fiscal management. “They agree with our concern that “there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.” Social security is still forecast to be insolvent by 2033.
• Rising general government deficits | Fitch forecasts a government deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025. Of special note was the impact from the combination of higher debt levels and higher interest rates. “The interest-to-revenue ratio (the percentage of government revenues to pay just interest payments) is expected to reach 10% by 2025 (compared to 2.8% for the ‘AA’ median and 1% for the ‘AAA’ median) due to the higher debt level as well as sustained higher interest rates compared with pre-pandemic levels.”

• General government debt to rise | Fitch projects the government debt-to-GDP ratio to rise over the forecast period, reaching 118.4% by 2025. They are concerned that“the debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3% of GDP and ‘AA’ median of 44.7% of GDP. Fitch’s longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks.”

• Medium-term fiscal challenges unaddressed | Fitch acknowledges the combination of higher costs (interest payments, healthcare, and other government spending) with the potential of lower tax revenues (political pressure is likely to build to extend the 2017 tax cuts set to expire in 2024) will lead to higher long-run deficits. Additionally, the annualized quarterly interest expense is expected to rise above $1 trillion this quarter for the first time on record.

The point: Versus comparable rated countries, the debt dynamics in the U.S. are worse (and expected to worsen over time). And given the lack of commitment by D.C. policymakers, the appetite to improve these conditions seems limited. The raising of the debt ceiling did not solve our issues, it just kicked the proverbial can down the road. Thus, Fitch felt the need to downgrade and send another message to Washington that this is an important long-term problem that needs to be addressed sooner rather than later. 

What would make us more concerned?

While we do not expect this to have a lasting impact on the financial markets and do not feel the need to adjust our views, there are some factors that we are watching very closely which could cause us to become more concerned.

• Moody’s downgrade | This downgrade by Fitch is the second time in U.S. history that a major rating agency downgraded U.S. debt (after S&P downgraded it in 2011). As of now, Moody’s is the only major rating agency with an AAA rating on U.S. debt. If they were to downgrade the debt, the U.S. would not consistently be viewed as an AAA rated country. This could have repercussions on what various investors and funds can hold and could modestly reduce the attractiveness of owning U.S. Treasurys.
• Successive downgrades | If the U.S. were to receive more downgrades by Fitch or other agencies and fall even lower on the rating scale, that would pose more concerns. Admittedly, the downgrades have been few and far between, so this remains a low probability but something worth monitoring.

• Economic crisis | If the economy were to experience a deeper and longer-lasting recession than we are forecasting, that would hamper tax revenues, increase spending and lead to even more debt that would have to be serviced. That could cause the forecast increases in debt to be too conservative.

• Less demand | Currently, the U.S. holds a special place in world as the most prominent reserve currency. As a result, demand for U.S. Treasurys remains strong and healthy and we have not seen any reduction in overall demand. However, any signs of instability could lead to less demand which could cause interest rates to increase. As of now, this remains a low probability.

The point: Assuming the U.S. does not experience a significant recession that causes the fiscal profile of the U.S. to deteriorate rapidly, we do not expect this to be a long-lasting issue.

What is the impact to financial markets?

If the deal passes, the reduction in uncertainty will be a net positive for the equity market. However, it is worth noting that the S&P 500 has been fairly resilient throughout the debt ceiling debate and is now at the highest level since August 2022 (up 10.3% year-to-date). This is largely due to market participants becoming more accustomed to brinkmanship and last-minute deals emanating from Washington.

• Equity market | Given the current market environment, we had already been cautious on risk assets in the near term with the S&P 500 having already priced in a lot of good news (e.g., recession forecasts being pushed out, Federal Reserve nearing the end of its tightening cycle, inflation moderating) and rising above our year-end target of 4,400. With the forward-looking P/E at 19x (and trailing at 21x), the equity market was vulnerable to a pullback. The downgrade from Fitch is another reminder for investors to not get complacent, as bullish sentiment has increased substantially from the beginning the year and is currently at the highest level in the last two years.
  
  
• Fixed income | While the knee-jerk reaction saw Treasury yields rise over 10 bps since the announcement, particularly longer-term maturities, we do not think there will be a lasting impact on the Treasury market. Why? First, we do not expect the ratings action will result in any forced selling from fund managers due to guideline constraints as the rating downgrade of one notch is still within the parameters of most mandates. Second, it is unlikely that market participants will demand an additional premium to hold U.S. Treasurys as investors do not have material concerns about the creditworthiness of the U.S. government. Finally, the U.S. still enjoys the safest, largest and most liquid bond market in the world. Furthermore, the moves in credit default spreads and the US dollar overnight have also been negligible. We maintain our view that high-quality bonds are attractive at current interest rate levels with the 10-year Treasury yield above 4% as we expect yields to reverse and end the year lower. The economy remains the biggest driver of yields and with our expectation of a mild recession unfolding as we go into 2024, 10-year Treasury yields are likely to fall toward our year-end target of 3.25%. 
• 2011 redux? | Using the last time the U.S. debt was downgraded in 2011 as a guide, this downgrade should not have a meaningful longer-term impact. In fact, most of worst-case investor fears did not come to fruition back then. After falling 8% in the aftermath of the downgrade, the S&P 500 was up 16% in the 12 months following, and demand for Treasurys was not dampened as the 10-year Treasury yield declined ~90 bps over the same time period.

The point: The debt downgrade does not alter our investment outlook for equities or fixed income. The headlines overnight and today may have been a catalyst for the sell-off in the equity market today that was already vulnerable given the strong rally to begin the year. As a result, we are not changing our equity targets as we maintain our long term optimistic view on equities. For bonds, our expectation of lower yields by year end make them attractive at current levels.

What is the impact of increasing treasury issuance on interest rates?

The news of a debt ceiling agreement, while not yet passed, is a positive development for the fixed income markets as it reduces the odds of a U.S. debt default. This has led to a narrowing in credit default swap spreads from a peak of 176 to ~140 and to lower yields on near-term Treasury bill maturities, which topped 6.50% in recent weeks. Assuming the debt deal passes, and we have high confidence that it will, market attention will turn to renewed fixed income issuance, particularly as the Treasury seeks to replenish its coffers, the Fed’s upcoming rate decision and the longer- term growth implications of the modest spending caps.

Yields have backed up considerably since early May as market expectations for the Fed have shifted toward the potential for another near-term rate hike, but we believe the combination of modest spending cuts and tighter liquidity conditions will remain a headwind to growth and inflation – and ultimately be bond market supportive. While increased issuance may weigh on Treasury yields in the near term, we forecast the 10-year Treasury yield will grind lower over the remainder of the year as growth and inflation subside.

Bottom line

The Fitch rating action does not change our longer-term asset class views but serves as a reminder that the fiscal trajectory is on an unsustainable path that our politicians must address sooner rather than later, particularly with yields now sitting at multi-decade highs.

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Thoughts on the Market

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