US credit rating downgrade – what it means for investors

 

August 2023 | 3 min read   

Fitch Ratings, one of the three main independent debt ratings agencies, downgraded the US debt credit rating, from AAA to AA+ with stable outlook, on August 1^st.

 

 

This decision was taken because of three main reasons:

1. the first is the erosion of governance in the US. In its report, Fitch mentioned the complex processes for setting the budget and raising the debt ceiling, which have become more difficult in recent times due to political divide between the democratic and republican parties. The rating agency also considered the absence of a firm plan to keep the Social Security¹ and Medicare² programs solvent;

2. the second reason is the rising general government deficit. The rating agency believes that the US budget deficit will rise from 3.7% of GDP in 2022 to 6.3% in 2023, due to weaker fiscal revenues and higher spending, as well as rising debt services costs. The general government deficit should increase to 6.6% of GDP in 2024, down from a surplus of 0.2% of GDP in 2022. This gap is expected to widen more in 2025 (6.9%). The US budget deficit is much higher than other countries with AAA rating, such as Germany and Australia. Fitch also estimates that the US interest-to-revenue ratio³ is expected to reach 10% by 2025;

3. the last factor is connected to an increase of the general government debt. Even if lower deficits and higher nominal GDP lowered the debt-to-GDP ratio from 122.3% in 2020 to 112.9% in 2023, it is substantially higher than the 100.1% of 2019. According to Fitch, this number should reach 118.4% in 2025. This figure is more than twice the median of 39.3% scored by AAA-rated credit issuers, according to the Organization for Economic Cooperation and Development (OECD).   

From a geopolitical perspective, we believe that this downgrade reflects the “new normal” in terms of US political volatility. Investors should consider this as a reflection of the political uncertainty that could grow further as the US presidential elections come closer. There is unpredictability also in terms of foreign policy, as presidential candidates could compete on who keeps the tougher stance towards China. However, this downgrade does not change our views on the overall US/China relations or on the Russia/Ukraine war. The downgrade should not impact significantly the voter behaviour or sentiment, as US citizens are more concerned about the real economy. Even if this downgrade is not a positive news, we think it should not influence significantly the result of the elections.

The initial reaction of markets’ participants was rather muted, as the Fitch report did not include anything new to the original announcement in May. The 10-year Treasury yield rose as a consequence of the jobs report made by the payroll processing firm ADP, which provides an independent measure of the state of the US labour market. There was an additional indirect effect, as markets realised that the US financing needs were higher than anticipated, pushing the Treasury yield close to 4.25%.

Fitch managed to prevent further negative effects by keeping its rating of US government-sponsored enterprises (GSE)⁴ at AAA, and not adjusting the US country debt ceiling. Indeed, this decision prevented ratings-sensitive investors to be forced to sell.In addition, the August 1^st downgrade from AAA to AA+ is not expected to weight on the demand from core institutional investors, such as commercial banks and pension funds. For the former, the lower end of the range to have a zero-capital requirement for government bonds’ is AA-; for the latter, one notch downgrade shouldn’t be enough to persuade them to change their investment decisions, rather focused on selecting long duration asset suitable to match long liabilities.

We believe that the US economy is growing well and inflation should have peaked, even if the path towards the Fed’s target is still volatile. However, we think that the appetite for bonds remains positive.

Looking at the possible long-term effects, Fitch has followed S&P in downgrading the US credit rating, and we think that Moody’s may also decide to reassess the US debt from stable to negative, and from AAA to AA+.

However, as long as the dollar remains the global reserve currency, there should be strong demand for US Treasuries, and no rapid rise in yields should occur. Today there seems to be no credible alternatives to the US currency, but this downgrade could have some negative long-term effects on the value of the greenback’s position as the world’s reserve currency.

Lastly, this downgrade reflects a material fiscal issues, as it points to a deterioration in the standards of governance and a worsening of government finances as growth slows down. This is also due to the lack of any joint efforts of the two political parties in addressing the staggering amount of government debt. In particular, the Congressional Budget Office forecasts that the US debt will be close to $50 trn in 2033, up from the $33trn of this year.

If you would like to learn more about what the US credit downgrade means for investors, read the Amundi Institute full article here .   

Sources:
¹ Social security is a program aimed at providing a source of income to retirees or people that cannot work due to disability. 

² Medicare is the national health insurance program in the United States, started in 1965, which provides health insurance for Americans aged 65 and older and to some people with disabilities.

³ The ratio is the percentage of interest payments over government revenue, such as income received from taxes and other sources.

⁴ GSE are privately held agencies established by the US Federal Government with the goal of improving credit flows to certain regions of the US economy. They can provide financial services to citizens, particularly mortgages.

Amundi Institute, US credit rating downgrade: investment implications, 8 August 2023

Important information

Unless otherwise stated, all information contained in this document is from Amundi Asset Management S.A.S. and is as of 22 August 2023. Diversification does not guarantee a profit or protect against a loss. The views expressed regarding market and economic trends are those of the author and not necessarily Amundi Asset Management S.A.S. and are subject to change at any time based on market and other conditions, and there can be no assurance that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, a security recommendation, or as an indication of trading for any Amundi product. This material does not constitute an offer or solicitation to buy or sell any security, fund units or services. All investors should seek professional advice prior to any investment decision, in order to determine the risks associated with the investment and its suitability. Investment involves risks, including market, political, liquidity and currency risks. Past performance is not a guarantee or indicative of future results.

Date of first use: 22 August 2023
Doc ID: 3060916