by Ralph Cole, CFA
Director
Equity Strategy and Portfolio Management
For years, our clients have worried about the ballooning debt situation with the U.S. federal government. Fitch Ratings, which is one of the three main credit rating agencies, verified these worries earlier this week when they lowered the U.S. government’s credit rating from AAA to AA+. While many called this a surprise move, others have been expecting this for some time.
Above is a chart of U.S. government outlays and tax receipts (revenues). We think Fitch is simply acknowledging that the federal government is on an unsustainable spending path. The last time the U.S. government’s debt was downgraded was in 2011 by Standard and Poor’s. Back then, our debt to GDP ratio was 66% and was projected to hit 77% by 2021. Currently, our debt to GDP ratio is 98% and is projected to grow to 130% by 2033.
Rating agencies can help act as a governor on federal spending. If you look at our first chart, you can see that spending as a percentage of GDP went down and remained stable after the S&P downgrade in 2011. We expect this downgrade to have a similar effect as we move forward in congressional spending negotiations. The environment will continue to be contentious in Congress as they grapple with spending and taxes in the coming years. Below is a chart that depicts the different ratings over time that the three rating agencies have given U.S. debt.
The next shoe to drop will be the bond market itself. With the downgrade this week, the yield on the 10-year treasury hit its highest level of 4.19% since October of last year. This, coupled with the highest fed funds rate since the turn of the 21st century will begin to squeeze the federal budget even more. Congress will be forced to do at least one of two things: spend less or raise taxes. Our expectation is that both will have to happen in the coming years. Ultimately, we agree with Fitch, there has been an “erosion of governance” in recent years.
Takeaways for the Week
Fitch Ratings downgraded U.S. federal debt for the first time in history from AAA to AA+.
While we realize in the short-term it may not have a large impact on the capital markets, we think this is a sign that Congress needs to get control of the U.S. budget in upcoming years.