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Market Commentary: August 2023 – Debt & Downgrades

Debt & Downgrades

August 2023

By Jonathan McAdams, CFA

“There are some things people shouldn’t worry about…this is one.”

Warren Buffett, Aug 2023

In a surprise move on Aug 1, Fitch Ratings, one of the major bond ratings agencies in the United States, downgraded their rating of US government debt from AAA (the highest rating) to AA+ (one notch down). While the timing of the downgrade was curious coming well after the debt ceiling standoff a few months ago, the commentary largely cited the “steady deterioration in standards of governance over the last 20 years” and “the repeated debt limit political standoffs” that have eroded the agency’s confidence. In short, the quirkiness of our debt ceiling statutes can make for a very messy political backdrop to US debt dynamics. As Kathy Jones at Charles Schwab wrote, “This is not about the ability of the US to service its debt. It’s about the willingness to service the debt.”

While this downgrade was not due to any major changes to Fitch’s US government fiscal or debt projections, that is not to say those financial trends are not without concern. The US has a mounting deficit and debt issue that will be difficult to mitigate without sufficient political will. The core of the issue is that the US has a chronic spending problem. This chart outlines Federal revenues and outlays as a percentage of GDP over the last 50 years, along with the Congressional Budget Office’s projection for the next 10 years. What it shows is that despite a myriad of tax regimes, Federal revenues typically oscillate around 18% of GDP and are influenced more by the economic cycle than anything else. However, Federal outlays as a percent of GDP, while also impacted by economic cycles, have structurally risen from 19% of GDP in 1972 to a projected 24% of GDP by 2032. While 5% may not seem like a significant increase, by 2032 this extra 5% of spending adds up to $1.8 Trillion of added deficits per year! And when combined with ballooning entitlements such as Social Security and Medicare, the Federal debt as a percentage of GDP is projected to balloon over the next 30 years.


To be fair, there are a multitude of variables at play and projecting out 30 years is an imprecise science, but the current trends are clear. The real question, however, is this: when do deficits and debts become unsustainably impactful? In a famous paper in 2010 by Carmen Reinhart and Ken Rogoff, they argued that debt levels of 90% or more to GDP were empirically shown to dramatically curtail future GDP growth. The paper was controversial and not without its critics, but the larger point that governments cannot indefinitely grow debt faster than they grow their economy was well taken. That said, Japan currently has a debt to GDP ratio of 263%, so drawing a hard red line at a specific debt to GDP ratio is not so straightforward.

For now, what we do know is that the US’s ability to pay its debt is secure. Debt interest costs as a percentage of Federal revenues are just under 10%, above the global average of 6% but far from alarming levels. Additionally, as we have mentioned in prior communications, the US dollar’s status as the world’s reserve currency provides a deep reservoir of buyers for US government debt – a dynamic that is unlikely to change soon since there are no other viable alternatives to the greenback. Ultimately, deficits and government debt are confidence games, and it is impossible to know when, if ever, the market would lose confidence in US debt.

Therefore, considering the Fitch downgrade and the uncertain US fiscal situation, what changes should be made to an investor’s strategy? The answer is few to none. We would argue leaning into areas that benefit from higher interest rates or higher inflation might make some sense at the margin over the long-term. But keep in mind that headlines have been screaming about the unsustainability of the US debt for the better part of 25 years – and have been wrong. If you had exited the market in fear in August of 2011 when Standard & Poors last downgraded the US debt, you would have missed a 372% return from the stock market (S&P 500) to today. The full faith and credit of the US government is still strong, we are still the world’s reserve currency, and the US economy is still the strongest and most resilient in the world. Yes, there are long-term concerns and fiscal responsibility needs to be addressed, but as Warren Buffett said, there are many other things to worry about right now – a debt downgrade is not one of them.

Shannon Dermody

Shannon DermodyTEST

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