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US Debt Downgrade:  A New Decade – Same Problems?

US Debt Downgrade: A New Decade – Same Problems?

August 02, 2023

Yesterday, Fitch Ratings downgraded the United States of America's Long-Term Foreign-Currency Issuer Default Rating (IDR) from 'AAA' to ‘AA+’.  At the same time, and despite that downgrade, the agency changed its outlook of Uncle Sam’s credit standing from “negative watch” to “stable”.   According to the agency’s report, the rating downgrade is signaling an expected deterioration of US fiscal operations over the next few years, growing government debt burdens, and also blames “governance erosion” in the beltway over the last 20 years that has continuously resulted in instigating, arguing and fussing between politicians and has only led to debt limit showdowns, empty political promises, and last-minute resolutions (also known as “can kicking”). 

Some of the issues surrounding the debt downgrade include the government’s universal refusal to cut spending, face revenue challenges responsibly, and maintain worthwhile macroeconomic policies.  In other words, and according to Fitch directly, the downgrade is a result of “a decline in the coherence and credibility of policymaking that undermines the reserve currency status of the U.S. dollar.” 

The Federal Reserve isn’t helping matters here, either.  Since March of 2022, Jerome Powell and company has voted to raise interest rates 11 times taking the Fed Funds Rate – which is the rate that banks charge when borrowing or lending overnight excess reserves – from 0.25% to 5.50%.  These rate hikes have created tighter credit conditions, have weakened business investment, and have generated a slowdown in consumption that could push the U.S. economy into a recession going into year-end 2023 and into Q1 – 2024. (This is according to Fitch’s projections as the agency sees GDP in the US slowing from 2.1% in 2022 to 1.2% this year and a total GDP growth rate of just 0.5% in 2024).

Fitch’s downgrade drew a blistering condemnation from US Treasury Secretary, Janet Yellen today, as she said the agency’s actions were “entirely unwarranted” and “puzzling”.  Secretary Yellen went on to say, “At the end of the day, Fitch’s decision does not change what all of us already know: that Treasury securities remain the world’s preeminent safe and liquid asset, and that the American economy is fundamentally strong”.  At the same time, The White House blamed political opposition for the downgrade saying that “political extremism” is the primary culprit for our country’s demotion from ‘AAA’ to ‘AA+’.  

As I ripped through all of the details of Fitch’s report, it became extremely clear to me that this downgrade is essentially a direct result of debt-limit political fighting, eroded confidence in fiscal and monetary policy, and a lack of the framework necessary to properly manage the extremely complex US Government budgeting process.  And these factors, alongside certain economic shocks and new government spending initiatives, will continue to contribute to successive debt increases for years to come in the Nation’s Capital as there has been very limited (if any) progress made in tackling more near-term challenges, such as rising social security and Medicare costs due to an aging population. 

But have we been here before?  Why yes, we have so let’s go back through history for a minute, shall we?  In August of 2011, S&P Global Ratings Agency downgraded US Treasuries for the first time ever, lowering the federal government’s credit worthiness from ‘AAA’ to ‘AA+’.  Earlier, in April of that year, ahead of a looming debt ceiling “fist fight” in Congress, the agency had lowered its outlook on US debt to “Negative Watch” from “Stable” and months later, S&P Global officially downgraded US bonds to ‘AA+’ just four days after the 112th US Congress narrowly escaped a buzzer-beating, last minute debt default resolution by finally voting to raise the debt ceiling through the Budget Control Act Bill of 2011.  Later, the US Department of Justice launched an investigation into S&P's rating activity of mortgage-backed securities that played a major role in the 2008 – 2009 Global Financial Crisis (GFC), and weeks afterward, S&P’s CEO was asked to leave by regulators and stepped down from the agency.   

Does any of this sound familiar after yesterday’s action taken by Fitch and can we USE history as a guideline? 

The title of this post suggests that we may be experiencing “déjà vu”, that investors should pay close attention to their surroundings and, indeed, use some history as a guide.  In 2011, after S&P’s government bond downgrade, the S&P 500 stock index fell by 7% in the blink of an eye, rattled global markets, and lost 15.5% of its value by October – only to finish the year unchanged at a break-even level, which is something that hadn’t occurred since 1970.  Taking a page out of history, while not 100% perfect, can, at the least, provide some direction on how investors should be managing risk in investment portfolios.  Will we repeat the same type of volatility that we saw in 2011 this year?  Of course, we all know that nobody can answer that questions with certainty, but it should influence all investors to assess portfolio risk and make appropriate and prudent adjustments in accordance with their objectives and overall tolerance for risk.

If you are regular reader of my posts, you already know this, but at Capstone, we are most mindful of investment risk management as we consistently apply discipline and process to asset management and we continue to align our asset allocation strategies with prevailing and observable economic/market conditions.  The investment advisory management services that we provide to our clients will adjust as conditions change and, as always, we continue to observe caution and maintain our fiduciary obligation in doing what is appropriate for all clients at all times.  

For any readers of this post that are not yet clients of Capstone, please feel free to contact us if you have questions about the markets, the economy, or, most importantly the risk that may be hiding in your portfolio for a no cost, no obligation review.  And as always, if you are a Capstone client, please contact us at anytime to discuss your investment portfolio and overall risk management at 888-587-7526 (toll free) or (570) 587-7800 (office direct).

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.