Fitch Flinches on U.S. Credit

Aug 8, 2023

By Ben Norris, CFA, Senior Investment Strategist, Vice President
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Of the three main credit ratings agencies in the U.S., two have now downgraded the U.S. to a step below the highest rating: AAA. In a largely symbolic move, Fitch Ratings moved its rating of the U.S. government’s creditworthiness down to AA+. This follows S&P Global’s downgrade in 2011 in the aftermath of the Great Financial Crisis and the extraordinary measures that the U.S. Congress and the U.S. Federal Reserve (Fed) took to support the economy. Fitch cited the government’s rising debt levels as well as political gridlock in its announcement—the decision “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 other countries with similar profiles. Both downgrades followed legislative standoffs tied to the U.S. debt limit and Congress’s inability to come to an agreement to raise the limit in a timely fashion. While the U.S. has never defaulted on its debt obligations, even the discussion of a technical default is enough to make most investors nervous.

If you imagine the U.S. as a public company, it probably wouldn’t have many investors. A business that is partially run by two sides that are willing to put the financial health of the company on the line to win an argument rather than compromise is not ideal. As Fitch put it, “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” Next, imagine a business that also consistently spends more money than it earns and makes up the deficit by borrowing. Dysfunctional management and operating at a loss are usually enough to get activist investors involved. Unfortunately, that isn’t an option for the U.S., so we’ll have to hope for real progress in Washington and for the Fed to learn from past mistakes. To be fair, a country and a company are not perfect comparisons, but the general idea here is that if America were a company, the board of directors would be talking about making some changes among the management team. Moody’s, the third large U.S. credit rating agency, has maintained the U.S. at a AAA rating for now, but a downgrade in the future would hardly be surprising.

Markets got off to a quiet start last week before the Fitch downgrade sparked a broad sell-off on Wednesday, which continued through Thursday and Friday. Growth stocks were hit particularly hard as interest rates spiked in response to the downgrade. The NASDAQ Composite (COMP) lost 2.2% on Wednesday, its worst daily return since February. The S&P 500 (SPX) and Dow Jones Industrial Average (DJIA) lost 1.4% and 1.0%, respectively. Full-week returns were similar with COMP, SPX and DJIA losing 3.0%, 2.3% and 1.1%, respectively. Yields on 10-year U.S. Treasuries began the week below 4.0% before reaching 4.2% by Thursday afternoon, continuing a trend of heightened volatility in bond markets relative to equities. While equity volatility did tick up last week—the VIX rose above 17.0 for the first time since May—the reaction to Fitch’s downgrade was much more muted than the 2011 S&P Global downgrade, which saw the S&P 500 fall more than 7% on the day of the announcement. The good news is that the lingering effects for stocks should be relatively limited—markets have fared well since 2011, and the more muted reaction this time around implies a lower level of investor concern. The bad news is that rising interest rates have already put some strain on consumer budgets (think higher mortgage and credit card rates), and this will only make matters worse.

While Fitch’s downgrade dominated the news in the second half of the week, it was a relatively impactful week for other economic and corporate data. The second-quarter earnings season continued to chug along, and with more than 80% of the S&P 500 finished reporting, the rate of companies reporting earnings above consensus expectations is about in line with history despite somewhat weak revenues. What has been surprising about this earnings season is the subdued price action for companies beating estimates. In general, stocks that report an earnings beat tend to rise in the day after the announcement—that has not been the case so far this season. My suspicion is that many of the stocks that are beating estimates have already run up year to date and are consolidating as earnings grow into stretched valuations.

The labor market saw some promising developments based on a variety of metrics. The June Job Openings and Labor Turnover Survey (JOLTS) showed that job openings fell to 9.5 million, the lowest number since 2021. A lower number here is a positive from the Fed’s point of view as they work to lessen the impact of the hot labor market on inflation. JOLTS also showed that the rate of people quitting their jobs fell to pre-pandemic levels. People tend to leave their jobs when they think things are going well, so a tick down here is just what the Fed is looking for. The ADP employment report came in higher than forecasts and saw an addition of 324,000 private sector jobs. Finally, wage growth came in a bit above expectations as the unemployment rate fell back to 3.5% from 3.6% prior. In general, the labor picture is better than many expected given the Fed’s unprecedented pace of tightening—there are signs that the market is cooling, but not so quickly that consumers should be concerned.

Rounding out economic data releases last week, the ISM Manufacturing and Services indices both ticked lower in their latest readings. The manufacturing component of the economy has been in contraction territory since November 2022, while the services component has managed to remain resilient despite growing headwinds. Looking to the coming week, inflation data will be the focus for investors with the Consumer and Producer Price indices for July scheduled for release on Thursday and Friday, respectively. These reports will be one of the few new datapoints the Fed will consider before they make another decision on interest rates at its September meeting.

Date Report Previous Consensus
Monday 8/7/2023 Consumer Credit (June) $7.3B $11.0B
Tuesday 8/8/2023 NFIB Optimism Index (July) 91.0 90.8
U.S. Trade Balance (June) -$69.0B -$65.0B
U.S. Wholesale Inventories (June) 0.0% -0.3%
Thursday 8/10/2023 Initial Jobless Claims (August 5) 227,000 231,000
Consumer Price Index Y/Y (July) 3.0% 3.3%
Core CPI Y/Y (July) 4.8% 4.7%
Friday 8/11/2023 Producer Price Index Y/Y (July) 0.1%
Core PPI Y/Y (July) 2.6%
Consumer Sentiment (August) 71.6 72.0


Links to previously published commentaries can be found at Investment Insights/Weekly Market Commentary/Market