Let the sunshine in; does a U.S. downgrade matter?

I have a knack for going on vacation with my family when markets riot. I recall being in Maine when S&P downgraded U.S. government debt to AA+ from AAA in August of 2011. I had taken my family to Cadillac Mountain in Acadia National Park to watch the sunrise.

Cadillac Mountain is the highest point on the eastern seaboard. Between October and early March, it’s the first place to see the sunrise on the east coast. We got up around 4am. Then returned to the hotel, where my family went back to bed for a few hours. I dialed into our global morning meeting.

When I’m asked to speak at that meeting, markets are at best jumpy. At worst, rioting. In 2011, they were rioting. I kicked off the call by saying I’d just come from Cadillac Mountain and not to worry, the sun rose. I saw it. Markets would settle, risk reprice, investor anxiety would subside. It did.

Does Moody’s downgrade of the U.S. government matter? Yes, but in a slow-bleed sort of way. Had fixed income markets thrown a full blown temper tantrum, we might have seen opportunities to extend duration. They didn’t, at least not yet.

The downgrade certainly adds emphasis to Washington’s fiscal profligacy. Congress appears to be leaning in. The downgrade was a mark-to-market of where we are with both government spending and a burgeoning debt load. Also, where we seem to be heading. 

Knock-on corporate debt downgrades may pressure credit markets. The U.S. downgrade could add to the cost of government, corporate and consumer debt servicing. In their downgrade Moody’s mentioned the U.S. fiscal deficit can reach 9% of GDP by 2035. It’s around 6% currently. Is this immediately alarming? No. Is it worth paying attention to? Absolutely. It’s a slow turning drag on growth.

There’s a narrative building about whether investors are being compensated for the risk embedded in credit markets. As we remain overweight credit across portfolios, it’s something I spend a lot of time evaluating with my team. We’ve trimmed back positions but continue to hold a small overweight.

Credit markets are expensive. So are equity markets. We’re favoring extended credit as an overweight for a few reasons. Global extended credit markets are yielding 7-8%. I think it’s reasonable to trim that carry by 100-200bps, for potential credit spread widening.

We don’t know where we’ll land with tariffs. Tariffs will weigh on consumption and corporate margins. High yield, over a cycle, has a beta to equity markets of about 0.35x. In English? High yield moves are typically about a third of the moves seen in equity markets. Yes, I’m oversimplifying to make a point. Also, not to geek.

Credit looks interesting relative to stocks. Six percent up on the S&P 500, as of this writing, lands you around 6200 on the index. The beta on stocks is 1x, versus 0.3x for high yield. I’ve seen moments where extended credit displayed an equity beta of 0.7-0.8x. The global financial crisis comes to mind. It takes an extreme left-tail event to get there. There’s an argument to be made for credit in a portfolio, if sized appropriately.

We’re not overweight equities because of valuation levels; they’re expensive. Throw in a cloudy outlook on inflation, growth and earnings thanks to tariffs. As I’ve mentioned, a recession isn’t our base case over the next year. But given heightened uncertainty, risks skew to the downside.

The Fed meets in June, then July. I believe they’ll hold the line on monetary policy. Markets early last December were expecting three (or more) rate cuts. I had initially penciled in two. Had we kept on course, maybe three in a goldilocks environment. That’s fallen to one, and I’m rounding up a bit to get there. There is no reason for the Fed to move early.

I think a similar observation can be made about markets. Consolidation and a little calming seem in order. The headline driven ‘whirling dervish’ run is due a pause. Take a beat. Unfortunately, it’s path dependent on Washington. Let the sunshine in…

Unless explicitly stated otherwise, all data is sourced from Bloomberg, Finance LP, as of 5/21/25.