The Fitch Downgrade Of U.S. Debt: What Are The Implications?

Are our leaders fiddling while the country burns? You make the call,

Introduction

I don't spend a lot of time on economic theories or pontification of the same. It's not my core competency, although I think I can hold my own with most folks. Nor is what you signed up to read. I am sure I hooked most of you with my wit and wisdom from 40-years of rig chasing.

All of that said, I think its occasionally appropriate to venture off the reservation a bit. Particularly when things occur on a macro basis, that we should all keep in the back of our minds.

With that in mind, let's discuss the Fitch downgrade of U.S. debt.

What happened?

Fitch, a credit ratings agency downgraded U.S. debt [Fitch release linked here] last week, and included some rather droll commentary in their missive. The funny-sort of, thing is it came out of the blue... as a surprise. Which is sort of shocking, as one wonders...why now? Here's a snippet that will clarify the matter for you.

In Fitch's view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025. The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade. Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.

Ah declare! The ratings agencies are tired of the constant bickering among our elected leaders on budget priorities and brinksmanship. Imagine that.

Does it matter?

Over the short term, not really. It didn't matter in 2011 when Standard and Poor, (S&P) cut U.S. debt to AA from AAA. Stocks plunged as a result, but then a funny thing happened. I'll let the WSJ tell it.

For example, a funny thing happened when Standard & Poor’s shocked the financial world 12 years ago: Stocks plunged, getting close to an official bear market, yet investors rushed to buy bonds, the very thing that had supposedly become more risky. Stocks remained unsettled for another couple of months, but an 11-year bull market marched onward.

See? It didn't really matter. Life went on then, and it probably will from the Fitch action. Until it doesn't. No one can predict the future, but there are concerns now that didn't exist in the last go-round. Again quoting the WSJ article-

Investors are drawing false comfort from the past and from the perception that fiscal scolds have cried wolf so often.

What's different this time is that this year for the first time in ...forever, U.S. debt exceeds GDP, and it's projected to go higher from here.

We are in unchartered territory

The U.S. has proven to have an amazingly resilient economy in the face of the struggles to recover from the Covid shutdown. No one in early 2020 predicted the rally that would begin from people adjusting to permanent changes in workflow patterns, helicopter money falling from the sky, and massive capital infusions ala government spending programs like the laughably named Inflation Reduction Act of 2022. The last three years wasn't supposed be like this. 

We were supposed to have a steep recession followed by a year or two of gradual improvement, and an eventual return to growth. What actually happened was a capital flight to equities as all that money worked its way through the system. Employment remains impossibly high as well. As a result markets have hit new highs, even as Treasuries have done the same. Something that doesn't occur in normal times.

Next year interest on the debt is projected at 3/4 of a trillion dollars, nearly a third of all discretionary spending. Does anyone think this can go on forever?

The core problem- Our system of government is broken

Let's agree that being an elected repsentative of the U.S. government is a pretty good job. It must be as people tend to hold on to these jobs until they are carried out-feet first. The pay is decent, but there are off the books perks that end up enriching elected officials waaaaay out of proportion to the rest of the population. Then of course, compare the Congressional retirement plan with your own. 

The main job once you are elected is being elected over and over again. A new election cycle begins the day after the old one concludes. What that leads to is the absolute inability to get meaningful legislation advanced, as officials shie away from hot-button topics. A day of reckoning may be coming, as the WSJ notes in another article on this topic-

During this year’s debate over raising the debt limit, for example, both parties shied from considering cuts to Social Security or Medicare. The programs, which benefit elderly and disabled Americans, are hugely popular across the political spectrum. A lower credit rating isn’t likely to change that fundamental political calculation.

Congress will have to act eventually, though lawmakers tend to wait until moments—not years—before a potential disaster to address it. Social Security’s trust fund will run out in 2034, meaning the government won’t be able to pay the full amount of promised benefits, the government estimates. And Medicare’s hospital-insurance trust fund will be able to cover all benefits until 2031.

Lawmakers will be forced to act on taxes far sooner, in 2025, when many of the most popular of the Trump-era tax cuts are set to expire. Fitch expects Congress will simply extend the tax cuts, reducing revenue and raising deficits.

To summarize. The people we elect to take care of the day to day and long term issues that revolve around running the government, don't do it because even to talk about it openly and honestly, would result in their not being re-elected.

Your takeaway

I certainly don't have any answers. Well, I do, but no one would listen. Because the answers are hard and painful. And, heck...I am part of the problem. If my Congressman, Michael Guest-a good Republican, were to come to me and say, "Hey Mr. Messler, I am voting to cut your SS Check, and pare back your Medicare bennies." He would be gone and hunting honest work the next day.

As the WSJ article notes, at some point we are going to have to deal with the out of control spending that's been put in place. But it's not today. Crack the champagne, the market’s going higher. For now.

Disclosure. The author is long most of the stocks discussed here.

Disclaimer. Nothing I say in this article should be construed as investment advice. It may look or sound like it, but it is not. I am not a CPA/CFA and have no formal training/certifications/licences in either discipline. In these articles I present analysis and relevant information that an interested investors may find instructive. I may be bullish, bearish, or neutral and will discuss why, but I am definitely not recommending you buy or sell any security I discuss. Investors should always do their own due diligence before plunking down their hard-earned cash. They alone are responsible for their investing decisions.