Does the US Downgrade Matter? Analyzing the Impact and Implications of the Recent Credit Rating Shift

The recent downgrade of the United States’ credit rating by Fitch Ratings from AAA to AA+ has raised eyebrows across financial markets and sparked conversations on what this means for investors, businesses, and the country’s economic outlook. Coming on the heels of a dramatic and highly partisan conflict over the nation’s debt ceiling, the downgrade provides an opportunity to assess the underlying concerns that drove this action, what it may signal for the future, and how it might impact various investment strategies.

A Brief History of Downgrades

This is not the first time the US government’s debt has been downgraded. A similar scenario played out in 2011 when Standard & Poor’s cut the US credit rating from AAA to AA+. Both downgrades were driven by concerns about the federal government’s growing deficit and prolonged political debates, highlighting a continued lack of resolve to cut spending.

What’s Behind the Downgrade?

The primary reason for the downgrade is the federal government’s failure to address rising debts. Once a topic of bipartisan concern, deficit spending has gained support in recent years, despite mounting evidence that higher debt is not conducive to faster economic growth.

Publicly held US debt reached 120% of GDP in 2022, far exceeding the historical average. Projections from the Congressional Budget Office (CBO) indicate further increases, with a total deficit of $13.1 trillion expected from 2023 through 2032. The Asset Allocation Research Team (AART) at Fidelity suggests that this trajectory is unsustainable, pointing to historical examples to support their stance.

Implications for the Economy

The downgrade also brings attention to broader issues related to governance, fiscal policy, and economic sustainability. The fact that Fitch expects “fiscal deterioration over the next 3 years” and highlights a steady deterioration in governance over the last couple of decades raises alarms.

AART believes that political pressures may lead to more active roles for monetary and fiscal policymakers in the economy, possibly resulting in higher inflation. The historical data presents a clear picture that perpetual increases in the debt/GDP ratio have not been sustainable in the long run.

Impact on Stocks

While stock markets generally react to economic growth and corporate earnings, they can become volatile during periods of concern about government fiscal wellbeing. Previous instances of the federal government nearing its borrowing limit have seen sharp market fluctuations. The 2011 downgrade brought prolonged volatility, indicating that the market could react unpredictably to the recent downgrade.

Impact on Bonds

Interestingly, despite the downgrade, the US Treasury bond market remains the largest and most liquid financial market globally. Institutional Portfolio Manager Lars Schuster points out that the situation hasn’t changed overnight and that investors may still look to Treasurys for safety.

Moreover, the downgrade could create opportunities for income-seeking investors by affecting the yields on Treasury bonds with longer maturities. The current inversion of the yield curve, which has reduced the appeal of longer-term bonds, could also see a shift.

What Can Investors Do?

Investors concerned about the potential impact of rising debt may consider diversifying their portfolios across a broad range of assets. This strategy can help mitigate potential volatility and lower growth stemming from the nation’s fiscal challenges.

The availability of online tools and professional planning consultants at Fidelity and other financial institutions can support investors in creating or refining investment plans aligned with the new economic landscape.

Conclusion

The recent downgrade of the US credit rating by Fitch is more than a mere reflection of political drama; it serves as a stark reminder of underlying economic challenges that have persisted over the years. While the immediate impact may be limited, the downgrade shines a spotlight on the continued failure to address the growing debt and may signal potential long-term implications for inflation, market volatility, and investment opportunities.

Investors and policymakers alike would do well to heed the lessons of history and the insights provided by this rating action. It’s a call to action that should prompt careful consideration of fiscal responsibility, sustainable economic strategies, and thoughtful investment planning for the future. Whether or not the US downgrade matters is a question with deep and complex answers, and the ramifications may unfold over time. What is clear, however, is that it presents an opportunity for reflection, analysis, and proactive decision-making for everyone involved in the financial ecosystem.