Does the downgrade matter?

Two months after the federal government narrowly avoided defaulting on its debt amid a highly partisan conflict in Congress, an unfavorable review of that drama is in. Credit rating agency Fitch Ratings has lowered its grade on the government's debt from AAA to AA+ and says that it "expects fiscal deterioration over the next 3 years." Besides that gloomy view of the near future, Institutional Portfolio Manager Lars Schuster says that Fitch's action also "reflects its view that governance on fiscal and debt matters has steadily deteriorated over the last couple of decades."

The downgrade moves the US out of the group of countries which hold the world's highest credit ratings from Fitch, which is one of 3 firms that evaluate the ability of governments and companies to pay back interest and principal to investors who lend them money by buying the bonds they issue.

This is the second time the US government's debt has been downgraded. The first downgrade took place in 2011, when credit rating agency Standard & Poor's cut the US credit rating from AAA to AA+, following a rancorous debate in Congress over the size of the debt. At the time, Standard & Poor's cited the growing deficit and the prolonged debate as reasons for the downgrade, much as Fitch has done 12 years later.

What's behind the downgrade

The fact that the federal government has suffered a second debt downgrade 12 years after the first one suggests that Washington's lack of resolve to meaningfully cut spending is an ongoing concern for ratings agencies and investors alike.

When US debt was downgraded following the 2011 debt-ceiling agreement, one of the reasons ratings agencies gave was the failure of politicians to confront rising debts. Not so long ago, members of both political parties expressed concern about the impacts of government debt and spending. Many Democrats as well as Republicans supported a constitutional amendment requiring a balanced budget and from 1998 to 2001, congressional Republicans and a Democrat president produced balanced federal budgets.

But since then, deficit spending that higher debt makes possible has gained bipartisan support even in a highly polarized political environment. Research from Fidelity's Asset Allocation Research Team (AART) suggests that higher debt is not a recipe for faster economic growth, and that the responses by policymakers to that debt can ultimately lead to higher inflation and more volatile financial markets than in the past.

Publicly held US debt topped 120% of gross domestic product in 2022, according to the US Office of Management and Budget. That's a level of debt far greater than the average over the past 50 years. And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion from 2023 through 2032.

AART believes the rise in debt is ultimately unsustainable. They say that historically, no country has perpetually increased its debt/GDP ratio. The highest levels of debt ever topped out around 250% of GDP. Since 1900, 18 countries have hit a debt/GDP level of 100%, generally due to the need to pay for fighting world wars or extreme economic downturns such as the Great Depression. After hitting the 100% threshold, 10 countries reduced their debt, 7 increased it, and one kept its level of debt roughly the same.

AART looks to these historical examples to consider what may happen in the US as public debt passes 100% of GDP. They expect political pressures for monetary and fiscal policymakers to take a more active role in the economy will lead to higher inflation in the future.

What may the downgrade mean for stocks?

Stock markets generally react over time to changes in the pace of economic growth, and the direction of corporate earnings and asset prices, rather than political events. However, the chart below shows that US stock markets have historically turned volatile during periods of heightened concern about the fiscal wellbeing of the federal government

Since 1985, the federal government has approached the limit of its ability to borrow more money to fund its activities on 12 separate occasions. Each time, stock prices experienced an increase in sharp movements up and down before eventually rising after the threat of a default on US Treasury securities diminished following an agreement to raise the debt limit. In 2011, however, when the federal government's credit rating was downgraded for the first time, volatility remained higher for longer than during similar periods of heightened concern about the government's ability to manage its finances.

What may the downgrade mean for bonds?

Despite the downgrade, the market for bonds issued by the US Treasury is still the largest and most liquid financial market in the world. Says Schuster, "This has not changed overnight. Investors looking for safety when things get choppy are still likely to turn to Treasurys."

The downgrade could also deliver some opportunity for income-seeking investors by pushing up the yields on Treasury bonds with longer maturities. Since 2022, Treasurys that mature further into the future have paid lower interest rates than ones that mature sooner. This unusual situation is called an inversion of the yield curve and has reduced the appeal of longer-term bonds for investors.

What can investors do about the debt?

Investors concerned that rising debt may cause higher volatility and lower growth in the future may want to consider further diversifying their portfolios by adding exposure to a wide variety of assets.