We anticipate little disruption in the current trends and believe that it would not be prudent to make investment changes based on it.
Yesterday’s downgrade by Fitch Ratings of U.S long-term debt from AAA to AA+ took many investors by surprise given the resolution of the debt ceiling crisis in late May and early June. However, the fiscal challenges created by Covid-19 stimulus and the partisanship during the debt ceiling negotiations are well documented, so the underlying rationale for the downgrade by Fitch is understandable. That being said, the basis for their timing is more unclear in our view.
There has been little progress towards curbing federal spending to shrink the U.S. budget following that stimulus. For reference, the U.S. is running annual budget deficits of ~5 to 6% of GDP and total debt held by the public represents ~98 to 100% of overall GDP per the Congressional Budget Office (CBO). The last major change to tax policy was the Tax Cuts & Jobs Act in 2017, which decreased tax revenues with no meaningful offset in spending. If one considers the situation going back to the GFC, it would appear to point to an earlier downgrade – such as the one effected by S&P in 2011.
In evaluating the market response to the announcement, it is really more about the timing than anything else – Fitch has not taken any action on the debt amidst deteriorating governance and a burgeoning deficit, so why now? In our view, it lacks timeliness and is inconsistent. In particular, their citing of partisanship is nothing new and is a difficult catalyst for us to understand.
We believe the important issue here centers around how this will impact investor demand for Treasuries. One could argue that it perhaps sets a higher floor for rates. However, given the diversity of the U.S. economy, the large tax base, the functional role of the U.S. dollar in the global economy, and the historical precedent of safe haven flight to Treasuries during geopolitical and economic crises, we expect this downgrade to do little to decrease demand in the near to mid-term. The S&P downgrade in 2011 was a seismic event, and in contrast, this Fitch move seems more like a tremor. Longer term, however, the question of fiscal responsibility in Washington D.C. is likely to become more relevant to investors, especially given its status as a hot button political issue coming into a presidential election year.
Outside of Treasuries, we anticipate little disruption in the current trends and believe that it would not be prudent to make investment changes based on it.
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