What Does the Debt Downgrade Mean?

I’m sure you’ve heard by now that the rating agency Fitch downgraded the long-term debt of the United States to AA+ from the previous AAA rating. Fitch’s rationale for the action was this: “The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.” At first blush, that all sounds pretty well-reasoned and rational. Federal government spending is on an unsustainable trajectory, and our politics have rarely been so polarizing. But I tend to agree with the many others out there who are questioning the timing of this debt downgrade. And I also believe that this action will have very little impact on the economy and capital markets beyond providing an excuse to take some profits after a massive surge in stocks this year (in the face of sharply higher interest rates).

Conveniently, there is some precedent for Fitch’s downgrade. Standard & Poor lowered its U.S. debt rating to AA+ from AAA on August 5, 2011. And similar to Fitch today, S&P appeared as concerned with political dysfunction as deteriorating financials. S&P wrote, “The downgrade reflects our view that the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenge.” Adding another parallel, the S&P downgrade came just four days after Congress broke a prolonged standoff by agreeing to raise the debt ceiling. I’m sure you’ll all recall that our current-day, fearless leaders recently rescued us all from financial calamity by agreeing to suspend the debt ceiling until January 1, 2025. I hope you detect my sarcasm.

Yet Fitch went ahead with its downgrade despite the resolution of that self-inflicted debt-ceiling crisis. An article in Bloomberg.com this morning read: “While that crisis was ultimately averted, Fitch nonetheless said that the repeated debt-limit clashes and eleventh-hour resolutions have eroded confidence in the country’s fiscal management.” Again, it’s hard for me to disagree with Fitch’s contention that our Congress is effectively dysfunctional. But I question the timing, given Fitch’s own criteria for a debt downgrade, best illustrated in a tweet yesterday by Harvard professor Jason Furman:

Debt downgrades are supposed to reflect a negative turn in an issuer’s ability to service its debt. Based on that notion, I agree with Larry Summers, who said the following in a Bloomberg interview yesterday: “If anything, the data in the last couple of months has been that the economy is stronger than what people thought, which is good for the creditworthiness of US debt.” I’ll be the first to admit I’ve been on the wrong side of this bet. But the reality is that the economic outlook has improved substantially, even in the face of a sharp increase in interest rates. Consumer confidence and spending continue to positively surprise, debt service ratios are very low and balance sheets are still in reasonable shape. Jobs are plentiful and incomes are rising briskly. Housing prices remain pretty firm, even if only due to constrained supply, and home equity has surged. Stock prices have been on a tear, creating additional wealth to spend. While inflation rates may stagnate or even increase a bit into year end, the Fed has clearly eliminated the worst-case scenario of sustained, ultra-high rates of inflation. And it’s worth noting that the ratio of gross federal debt to GDP has been on a downward trend over the past three years, even though deficits remain very high and interest rates have been rising. And last but certainly not least, the debt ceiling standoff has been resolved until 2025! 

So yes, the growth in federal debt is on an unsustainable path, and the issuance calendar is very heavy over the coming weeks. And yes, risk assets are richly valued, especially given the sharp increase in interest rates. And yes, plenty of economic risks remain, including tighter bank lending standards, the depletion of consumer savings and a lot of debt that needs to be rolled over at higher interest rates. But there is little doubt that the U.S. economy has outperformed the vast majority of economists’ predictions. So, I don’t see this Fitch downgrade causing a major disruption to the economy, the capital markets or the US government’s ability to fund its profligate spending.  When S&P downgraded the U.S. in 2011, it turned out to be just a minor footnote in financial history. A few weeks from now, I suspect this time will be the same. All that said, stocks were clearly overdue for a breather, and this downgrade has proven to be the catalyst. Prior to today, the S&P 500 and Nasdaq had produced total returns, including dividends, in excess of 20% and 37%, respectively, for the year. And while there are fundamental underpinnings for the strength, a lot of it has just been momentum. There has been precious little bad news to stop the upward trend. Today’s downgrade is bad news, but it’s not an unfolding disaster. Blowing a little froth off the top of the market, backfilling and consolidating, taking a breath after an extended rally – pick your metaphor – isn’t a bad thing, especially as we come to the end of the summer and the traditionally volatile third quarter. The market reaction today is, I think, reasonable: Backing off 1%-2% – a bit of a sell-off, but an orderly one. There is no cause for panic, and I don’t see any signs of panic. And, of course, we must always remember that if somehow a bigger crisis does develop, the dollar and U.S. Treasuries serve as safe havens in times of crisis.