U.S. Credit Rating Downgraded by Fitch, Now What?

On August 1, Fitch Ratings downgraded the U.S.’s long-term default rating to AA+ from AAA. Fitch cited an “expected deterioration over the next three years”, a high and growing debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades. Fitch further noted the deterioration in governance has led to repeated debt limit standoffs and last-minute resolutions.

This is not the first time a ratings agency has downgraded the U.S.’s long-term default rating. Standard & Poor’s downgraded the U.S. to AA+ from AAA in 2011 following debt ceiling brinksmanship standoff in Washington D.C. Then the U.S. was able to avoid default. You can learn more about how this was avoided through the following link: S&P cuts US debt rating to double A plus | Financial Times (ft.com)

The lower credit rating should lead the U.S. to pay higher interest rates on its notes, bills, and bonds. This would drive up borrowing costs across the economy and lead to lower valuations within equity markets. However, the economic environment will obscure these affects. When S&P cut the U.S. rating on August 5, 2011, stocks initially declined as much as 12.6% following the downgrade. Equity markets were volatile for most of the next two months, but by the end of 2011, equities were above the levels of early August. The 10-year Treasury was at 2.56% when S&P downgraded the U.S. but fell to 2.0% a month later.

One difference in the equity markets today compared to 2011 is valuations are more elevated now. This difference opens the door to more of a sell-off in equities as markets adjust to the downgrade and could support the long-end of the bond market, inducing lower rates.

S&P downgrade US

We really don’t know what effect the downgrade will ultimately have, we think rates will be higher than what they would be otherwise, but this is ultimately unknowable. The macro-and micro-economic environments will dictate interest rates and equity prices. With that said, as of today, August 2, 2023, the economic backdrop is good. The ADP employment report showed that businesses with fewer than 250 employees added 389,000 to payrolls in July. Conversely, mid- and large businesses cut 81,000 jobs. This is a strong employment report for now and the future. The small businesses that added to headcount typically pay less than the mid-large size businesses, thus wage growth will likely fall, reducing inflation pressures later this year and into next. This would increase the odds that the Fed can generate a soft-landing in the economy rather than a recession. Lower inflation pressures and a slower economy has resulted in lower interest rates in the past and there is no reason to believe this time will be different. Furthermore, equity prices will recover because corporate margins and profits will recover and move higher over time.

Although, there is no way to know what the effect of the downgrade will truly have on rates and the economy; we will continue to work diligently to find those investments that fit with the economic conditions and are appropriate for clients.

Let’s continue the conversation. Comments are always welcome and if you have any questions, please call 503-292-1041.