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