Fitch’s U.S. downgrade: no impact on our market outlook

What happened

• Yesterday evening, Fitch Ratings – one of the “big three” ratings agencies – downgraded the U.S. long-term credit rating by one notch to ‘AA+’ from its top-tier ‘AAA’ status.  It has moved the U.S. from Rating Watch Negative to a Stable Outlook following the decision. In Fitch’s own words, the downgrade reflects “the 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.”
• S&P Global Ratings – another rating agency – has maintained a ‘AA+’ rating on U.S. government debt for the past 12 years, when it lowered its rating from ‘AAA’ in response to the debt ceiling standoff in August 2011. Moody’s continues to assign the U.S. it’s top rating of ‘Aaa’ with a Stable Outlook. 
• The initial U.S. equity market reaction to the downgrade is a slight pullback in the S&P 500, which is indicated down about 0.6%, relatively mild compared to its sharp rise over the past five months. International markets are down 1% to 2% this morning. Thus far, the reaction in the U.S. Treasury market has been particularly benign, with the 10-year U.S. Treasury yield falling (i.e., prices rising) overnight from 4.05% to 4.01%. 

Our take

Despite Fitch’s warning of potential negative rating action in May, the debt ceiling agreement reached on June 3rd eased concerns around the threat of a downgrade. Thus, Fitch’s decision comes as an oddly timed surprise for domestic and foreign investors. The rating downgrade is in response to well-known concerns: sustained budget deficits, rising federal debt load, and the use of brinksmanship tactics around fiscal deadlines. These issues have been highlighted by the Congressional Budget Office for a long time – and as recently as a month ago.

To be sure, the U.S. government faces significant challenges over the next decade to address issues such as higher interest payments, rising healthcare costs, and bipartisan dysfunction. Nonetheless, Fitch’s decision to lower the U.S. credit rating to AA+ does not change our extremely high level of confidence in the United States’ ability to pay its bills nor the power behind the full faith and credit of the U.S. government. It’s also unlikely to alter the divisive discourse in Washington D.C., especially in the near term.

Bottom line 

Fitch’s downgrade doesn’t change our big picture view of the economy or markets. In her statement last night, U.S. Treasury Secretary Janet Yellen wrote that U.S. government securities “remain the world’s preeminent safe and liquid asset.” We unequivocally agree. More importantly, from a strategy perspective, it doesn’t alter our overall market stance where we maintain neutral positioning in stocks, bonds, and cash given today’s prevalent macro crosscurrents. Within fixed income allocations, we reiterate our up-in-quality bias.