Fitch Downgrades U.S. Debt
- Fitch downgraded U.S. debt from AAA to AA+, citing concerns around debt levels.
- The timing of the downgrade is strange but could lead to less volatility than S&P’s downgrade in 2011.
- Risks remain in markets, and we expect more volatility in the second half of this year.
Yesterday, Fitch Ratings downgraded U.S. debt, sending bond yields higher and equities lower. Though timing is a bit strange, this downgrade now adds another concern for investors, adding to elevated valuations, economic uncertainty, and a potential Federal Reserve policy mistake. While the news of the downgrade is concerning, we have 2011 as a guide, as this isn’t the first credit rating agency to downgrade the United States. Based on the last downgrade, we expect this new downgrade will likely increase market volatility. However, better- than- expected second- quarter corporate earnings and a resilient U.S. economy will likely offer some type of downside protection.
On concerns around the impact of rising interest expense and increased government spending, Fitch Ratings downgraded U.S. debt from AAA to AA+. Specifically, Fitch cited, “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.” Besides the United States, Denmark is the only country with a debt process requiring agreement from political parties to raise the debt limit, as the constitution requires.
As a result of the downgrade, financial markets are now pricing in higher risk, as the yield on the 10-Year U.S. Treasury rose to its highest level since last November, equities are lower, and the VIX, a measure of market volatility, is higher.
We mentioned the timing is strange, since the debt limit was signed into law on June 3. It took nearly two months after this issue was resolved for Fitch to downgrade U.S. credit. They did cite growing debt levels, but the current “last-minute resolution” was resolved. While the timing is peculiar, it may be better than 2011 when Standard and Poor’s downgraded the U.S. amid the debt ceiling debate, causing more volatility. Waiting to issue the downgrade after the debt ceiling negotiations may create less volatility this time around.
Typically, bond investors do not put a large weight on credit ratings, which tend to be stale and outdated. They tend to have their own internal ratings, independent of rating agencies. One could argue this downgrade is long overdue and outdated. S&P downgraded the U.S. over ten years ago and the reasons Fitch cited in the downgrade were old news. Bond investors have been aware of these concerns for many years, so the concerns mentioned in the downgrade are unsurprising, and bond investors should have largely accounted for them already.
Looking back at 2011, S&P downgraded the U.S. on August 4, 2011. Again, this was in the middle of the debt ceiling debates adding to already heightened tensions. The S&P 500 sold off around 7.5% in just a few days but was above the level it started in less than two weeks. We would expect volatility to be less this time around as it isn’t the first time we have seen a downgrade, and the timing is better. However, as mentioned earlier, this is just another reminder of market risks, which have been climbing a wall of worry, as the old Wall Street adage goes. Furthermore, one potential limit to the market downside could be earnings, which have been surprisingly strong for the second quarter, with over 82% beating expectations so far.
We think a recession is still possible over the next 12 months, but we think it could be a mild recession. A strong labor market and service economy could hold up the economy as companies adjust to higher interest rates. Markets could be volatile; however, we do expect market fluctuations. We reiterate our recommendation for increased diversification. Please continue working with your financial professional to help you align your portfolio with your long-term investment objectives. Creating a financial plan you can monitor and follow helps avoid distractions and stay focused on what you can control.
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