If you were watching the news on August 1st, you could not have missed what looks like former President Trump’s third indictment, but you may have missed another notable headline. In the evening, credit rating agency Fitch Ratings (Fitch) announced a downgrade of US Sovereign debt from AAA to AA+. This is the second downgrade in about ten years after Standard & Poors (S&P) did so in August of 2011. The reaction was swift and predictable, but what does this actually mean for investors and Americans alike? Let’s take a quick look at the situation.
Who is “Fitch Ratings” and what do they do? Fitch is one of the three major rating agencies (Fitch, S&P, and Moody’s). Rating agencies assign credit ratings to companies, countries, and other entities that issue debt. Their goal is to provide objective analyses and independent assessments of issuers for use by retail and institutional investors. Together, the “Big Three” comprise about 90% of the credit rating market.
What did Fitch do? On August 1, 2023 Fitch announced that they were downgrading the US from AAA to AA+ citing “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.” Fitch is not the only credit rating agency to do so. In 2011, S&P downgraded the US as well from AAA to AA+. Moody’s still has the US at Aaa (their highest rating given).
What was the reaction to the downgrade? Widespread head scratching. The White House and the Treasury naturally disagreed with the decision. Economists questioned the move with Larry Summers, a former US Treasury Secretary, calling it “bizarre and inept.” Mohamed A. El-Erian noted on twitter “I am very puzzled by many aspects of this announcement, as well as by the timing. I suspect I won’t be the only one.” Jamie Dimon, CEO of JPMorgan, called the move “ridiculous” and “They point out some issues which we all knew about.”
What does the downgrade actually mean for investors? Most likely not much. In 2011 after the S&P downgraded the US, there was a sell off of about 6.7% in the S&P 500 in a day. The market tumbled down about 20% from July 22, 2011 to August 8th, 2011, with the downgrade on August 5, 2011. The market actually bottomed out 2% lower in October before rallying. The markets had volatility, but it wasn’t until 2018 that the S&P 500 actually had a negative total return.
Interestingly, the biggest concern with a downgrade in credit quality would be the expected increase in yields. If an issuer receives a lower credit rating, the rating implies the issuer is less creditworthy therefore investors would require a higher rate of return. Except, this didn’t really happen. It took almost two full years for the 10-Yr treasury to reach the same level of rates it had in 2011 at the time of the downgrade. Even then, rates declined again in 2014 until they finally began an upward trend in 2016.
Currently, the markets seem to be taking the news in stride. The day after the announcement there was a mild pullback in the equity markets of about 1-2.5%. Yields have risen this time a bit on the 10-Yr treasury but not at an alarming rate. Increasing yields could put some pressure on the equity markets, but a mild pullback could actually be healthy for the markets after the year they’ve had.
Why are the reactions a bit different this time? It might be natural to question why the markets haven’t reacted as much this time as compared to 2011, but it’s important to look at how the economy is much different. In 2011, we were as a country two years removed from the most severe economic downturn since the Great Depression. Unemployment was above 9% in 2011, while today it’s under 4%. The economy seems to be accelerating currently despite higher rates and inflation, while the economy in 2011 was on shaky ground still. Things could change economically in the future but currently the biggest effect of this downgrade might be psychological.
Jamie Dimon may have said it best when he remarked that “they point out some issues which we all knew about.” Fitch’s downgrade of the US debt didn’t tell us anything new or point out things we didn’t already know. We have a large and growing debt burden which could be troublesome if we continue to allow political games drive us to the brink, but it need not occur. The debt is large, but so is our economy. It can be handled with decent economic growth, continued innovation by our people and companies, and sensible fiscal policies. The US economic engine is not going to stop simply because of this. Perhaps the best thing to come of this downgrade will be helping our elected leaders to make better decisions on economic policies.