The US Downgrade — Market Insights (July 2023)
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The US Downgrade — Market Insights (July 2023)

17 Aug
15 Aug

Fitch lowers US rating from AAA to AA+

In a belated decision, Fitch Ratings, one of the top three global credit rating agencies, downgraded the US sovereign debt from the top rating of AAA to the next tier, AA+, on 1 August 2023. This was a surprise for many as the debt ceiling gridlock had been resolved two months prior. 

Fitch cited a few main reasons for the downgrade:

  • Expected fiscal deterioration over the next three years
  • A high and growing general government debt burden
  • The erosion of governance relative to AA and AAA rated peers over the last two decades has manifested in repeated debt limit standoffs and last-minute resolutions

This downgrade comes more than 10 years after another credit rating agency, S&P, downgraded the US sovereign debt from AAA to AA+ with a negative outlook during a similar debt ceiling gridlock in 2011. S&P, at that time, cited heightened political polarisation and insufficient steps to get the nation’s budget under control. It went on to revise the outlook to stable in 2013 while keeping the AA+ rating unchanged.

With Fitch’s latest downgrade, Moody’s is now the only major credit rating agency to award the US with the coveted AAA rating.

Source: Trading Economics. As of 1 August 2023.

Implications of the downgrade

After the downgrade by Fitch was announced, yields on the 10-year US Treasury bond rose by a small margin. Moreover, yields continued to rise on the back of several announcements — the US Treasury department announced a larger-than-expected auction of US bond sales across the maturity spectrum, and the Bank of Japan (BoJ) announced the beginning of the exit of yield-curve control. BoJ is one of the largest investors of US Treasury bonds. Concerns that there may be less demand for US Treasury bonds sent yields rising.

Despite the concern over a larger debt interest, the US Treasury market is the largest and most liquid in the world, and therefore it will likely remain the main safe haven asset, notwithstanding the downgrade.

  • The US economy is still growing, inflation appears to have peaked, and unemployment is still low. 
  • The US dollar (USD) remains the reserve currency of the world, and there is currently no good alternative. This should help to keep demand for US bonds relatively high and thus also keep yields from rising too much.
  • The US debt market is the largest in the world, with about US$51.3 trillion dollars of outstanding debt, and its government debt stands at over US$26 trillion. As most investment mandates refer to Treasury securities specifically, rather than AAA-rated government debt, and as Fitch did not adjust its “country ceiling” at AAA, the impact on Treasury securities and on other AAA-rated securities issued by US entities should be limited.

We also believe there are a few key differences between the time S&P downgraded US Treasury to AA+ in 2011 versus the current downgrade by Fitch to AA+:

  • First, the US economy is much more resilient this time around, with the US unemployment rate below 4% vs (9% seen in 2011). 
  • Second, the spending cuts that ended the debt ceiling crisis of 2011 reduced federal spending by 0.7% of GDP the following year, while this time it is likely considerably lower.
  • Lastly, even on a global level, 2011 was coming on the heels of a debt crisis in Europe. 
Source: Advisor Channel by Visual Capitalist, as of April 2023; Endowus Research

What this all means for our clients is that there may not be a need to start divesting investments that hold US Treasuries. US Treasury securities are still some of the safest and most liquid investments in the world and for now, nothing has changed.

July market commentary

The global equity markets continued to generate positive returns as investors stayed in risk-on mode. In a reversal from the first half of this year, emerging markets outperformed developed markets. The US had a moderate month in July, with the S&P 500 index returning about 3.2% in USD terms. In terms of factors, global value stocks did better than growth stocks by a slight margin, while small-cap stocks outpaced their large-cap peers, in a contrast to their performance in the first half of 2023. China had a strong July as the Chinese government announced measures to stimulate domestic consumption.

In the fixed-income markets, returns for global government bonds were generally negative in July 2023 as the risk-on sentiment bled over to fixed income. Corporate bonds did well, outperforming government debt while high yield across the Eurozone, US, and emerging markets did better than investment-grade debt.

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It is almost impossible to predict exactly how macro events would play out. However, spreading your investments across asset classes and geographies will help with diversifying your risk. With market volatility comes opportunities. If you have a long-term investing horizon, as many of us do, these developments may offer an opportunity through steady, regular investing in diversified and risk-adjusted portfolios.

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