Investment Comment
4th August 2023
Credit rating, interest rates and equity ratings
After a relatively sanguine July, the move by Fitch Ratings, on August 1st, to strip the U.S. government of its top-notch AAA credit rating has seemingly rattled investors. The reasoning by Fitch highlights both the fiscal challenges, as budget deficits remain high, and the “Erosion of Governance”.
The downgrade due to elevated budget deficits and the forecast of rising government debt fits into the traditional narrative of those seeking better fiscal discipline. The US was running a government budget deficit of 5.8% of the economy in 2022-23, this is forecast to increase to close to 7% by 2025. From 1973 to 2022, the annual deficit averaged at 3.6% of the economy. In coming years, overall government debt as a percentage of the economy will be about two and one-half times its average over the past 50 years. This is a pattern common across the developed world, as aging populations and falling economic growth threatens longer term fiscal resilience in the absence of Quantitative Easing (bond buying) by Central Banks.
Fitch explicitly mentioned the erosion of governance reflecting the growing partisan divide between Democrats and Republicans and the complexity in the US Budget process. This is especially pertinent given the longer-term fiscal challenges around Social Security and Healthcare costs as the US population ages (a similar problem exists in the UK). The lack of consensus and compromise in the political system make good fiscal choices more challenging.
The erosion of trust in the US political system is emphasised in the Fitch report. Fitch had warned during the debt-ceiling standoff earlier this year that it was considering a downgrade because a country refusing to pay its debts in a timely way was not entitled to a AAA rating. It is the same reasoning used by Standard & Poor's (S&P) rating agency in 2011 when it downgraded U.S. debt to AA+ from AAA.
Fitch is the second of the 3 major credit agencies to downgrade the US Government debt from AAA following the S&P downgrade in 2011. Back in 2011, after the political stand-off around the Budget, the S&P downgrade combined with other factors, such as concerns over Greek debt default, to push US equity market lower by around 20% over the next 2 months. Through the same period the US bond market rallied, despite the economy continuing to register robust growth. Since the Fitch statement on Monday both bonds and equities have eased back about 2%. Whilst the downgrade may have been the catalyst for the market turbulence, the US equity market had become overbought and seemingly complacent about ongoing risks. Albeit the Fitch rating change probably wasn’t on the bingo card as a potential factor to upset the investor applecart.
As a result of increased supply of US Treasuries that will be sold onto the bond market (from both the Government Budget Deficit and the Federal Reserve rolling back Quantitative Easing) investors, over time, will demand more term premia, or higher yields for the risk of holding US long-term government debt. But in reality, the alternative to holding US Treasuries are limited if an investor is seeking AAA rated bonds. The group of countries that still get top marks on their credit worthiness is a declining bunch. Australia, Germany, Singapore, and Switzerland still have the top ratings from all three ratings firms, but whose bond markets are dwarfed by the size of the US government bond market.
Oil
Since the $120 per barrel price peak in June 2022, oil prices fell back to $70 in June 2023. This has been one of the drivers for lower inflation over recent months, just as it was a cause of inflation last year. The climb back to $80 may be a concern for those investors banking on lower inflation through the rest of 2023 and into 2024. Both Saudi Arabia and Russia have curtailed output and exports to boost the oil price.
In the US, the oil price is quickly reflected in petrol (gasoline) prices. Estimates suggest that the $10 oil price shift will add 0.2% to the inflation rate in coming months. This may not sound much, but the path of inflation is key for the Federal Reserve, and unhelpful increases in headline inflation rate may result in the Central Bank raising rates further than expected.
After a solid rally in July, news of a credit downgrade and the potential inflationary impact of higher oil prices is depressing investor sentiment at the start of August. In retrospect, higher bond yields were a major catalyst to the derating (and fall in prices) of equities in 2022. With equity valuations full, and investor optimism seemingly high, a little bad news can have outsized price impact on the downside.
Gerard Lane Chief Investment Officer
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