There are long-term challenges from high and growing U.S. debt, but Fitch’s downgrade doesn’t change our outlook for stronger markets this year.
Our Top Market Takeaways for August 7, 2023
Market update
Summertime sadness
August started with a stumble. After a strong run, stocks had a tougher time last week as bond yields moved higher. Now back above 4%, 10-year Treasury yields at one point hit levels unseen since November. Meanwhile, yields for shorter-dated bonds have barely budged (bets are still on that July’s Federal Reserve hike was the last).
So then, what’s behind the moves?
Fitch’s U.S. debt downgrade. Last week, Fitch (one of three major credit rating agencies) downgraded the U.S. government’s credit rating to AA+ from AAA (the highest possible rating). But that’s just one reason, and probably not the most important one…
- A better growth backdrop. The data for a still-strong, albeit slowly cooling U.S. economy, continues to roll in. More on that later.
- A ramp-up in Treasury issuance. The U.S. Treasury (the pocketbook for the government) said it plans to boost bond sales a bit more than expected. All else being equal, more supply can put downward pressure on prices and upward pressure on yields.
- Jitters from the Bank of Japan’s (BoJ) policy tweak. Policymakers eased their grip on their yield curve control (YCC) policy just over a week ago, calling its current 0.5% ceiling a “reference” instead of a hard limit. Given the BoJ has kept policy easy while the rest of the world hiked, some are taking it as a sign that one of the last “anchors” of global interest rates is coming loose.
To us, the move higher in yields doesn’t necessarily seem like a bad thing, especially as it, in part, reflects a world with better growth and easing inflation. Given the S&P 500’s ~18% year-to-date ascent, frothy valuations in some pockets of the market and low liquidity as traders hit the beach, we wouldn’t be surprised by choppy markets or even a late-summer swoon. But with the near-term macro and micro backdrop holding up, we still have an outlook for stronger markets over the next year.
Spotlight
Let’s talk about the U.S. debt downgrade
In its downgrade move, Fitch called out the U.S. government’s ongoing reliance on debt to finance its spending (with deficits expected at ~6% of GDP over the next three years). Over time, that adds to the already ballooning total U.S. debt stock: Federal debt held by the public is now ~97% of GDP. That’s a lot, and managing it has been made all the more complicated by division in Washington.
The chart describes the size of U.S. debt since 1920. For the line, the first data point came in at 27.3% in 1920. Then it went down and bottomed at 14.9% in 1929. Shortly after, it climbed all the way to 112.7% in 1945. Before falling all the way and bottomed again at 24.6% in 1974. It then slightly rose until it plateaued at 49.2% in 1994. Later it fell again to 31.5% in 2001. Then it rose up until it peaked at 98.4% in 2021. The last data point came in at 96.
The first and only other time the United States faced a downgrade was during the 2011 debt ceiling episode, when Standard & Poor’s similarly demoted the U.S. to AA+ from a AAA rating (a move that was never reversed). This means Moody’s is the only major rating agency that still puts the U.S. in the highest category.
So should you be worried? Here’s how we think about it:
What we’re not worried about:
- Default. The U.S. government remains in a strong position to keep making its interest payments. The issues that prompted the move are known problems, rather than a reflection of any new news. Fitch also said back in May (when all the debt ceiling drama was still in motion) that it was weighing downgrading the U.S. government’s credit rating. If anything, it was more just the timing of the announcement that was a surprise.
- Today’s economy. The labor market is still strong (the economy added another healthy amount of jobs in July, albeit at a slightly cooler pace). Consumers are still spending (fwiw, Taylor Swift just added more dates to her North American tour). And that broad economic strength is showing up in a number of bellwether companies’ earnings (take manufacturing giant Caterpillar, for example, which soared to record highs on a blockbuster report last week).
What we’re worried about now:
- A potential government shutdown. While the debt ceiling has been suspended until January 2025, the budget for the new fiscal year has to be approved by September 30 (in less than two months). With the government’s debt burden in such acute focus, spending disputes across and within party lines seem likely. This means that the possibility of a government shutdown can’t be ignored. We’ve dealt with the risk and reality of shutdowns many times before, but such episodes also tend to lead to some — albeit short-lived — market and economic angst.
What we’re worried about later:
- The long-term problems of a lot of debt. Michael Cembalest, our Chairman of Market and Investment Strategy, has called out how, over time, growing debt can crowd out other types of productive spending.
The larger the pile of debt, the more the government has to pay in interest expense. This makes decisions harder over how to allocate discretionary spending (such as healthcare, transportation infrastructure, science, education, and the like). At some point, government spending on entitlements, other mandatory outlays and debt interest will outstrip its revenues, and this will probably lead to a painful wake-up call for policymakers — but it may just take another decade or so to get there:
The top chart shows Entitlement spending and Non-defense discretionary spending from December 1965 to December 2033. The first data point came in at 2.6% for Entitlement spending and 3.8% for Non-defense discretionary spending. Entitlement spending rose to 7.3% in 1982 while Non-Defense discretionary spending rose to 4.2% in the same year. In 1991, Entitlement spending declined to 6.6% and Non-defense discretionary spending fell to 3.5%. Entitlement spending increased to 7.8% and Non-defense discretionary spending fell to 3.3% in 2001. In 2011, Entitlement spending saw another increase to 10.1% as did Non-defense spending as it reached 4.2%. Entitlement spending hit its peak in 2020 reaching 11.8% and Non-defense spending reached 4.3% that same year. By 2033, it is estimated that Entitlement spending will reach 13.8% and Non-defense spending will decline to 3.1%. This chart also shows the ratio of Entitlement to Non-defense spending. In 1970, the ratio is 1.1x. The ratio in 1990 is 2.0x. In 2000, the ratio increases to 2.4x. In 2015, the ratio is 3.1x. The ratio decreases in 2021 to 2.8x. Finally, the ratio is expected to reach 4.5x in 2033. The bottom chart shows the Entitlements + Other Mandatory Outlays + Net Interest, Revenues, Entitlements + Other Mandatory Outlays, Entitlements, Non-defense, and Defense from 1965 to 2053. The first data point for Entitlements + Other Mandatory Outlays + Net Interest is 5.7%. The first data point for Revenues is 16.5%. Entitlements + Other Mandatory Outlays starts at 4.5%. The first data point for Entitlements is 1.3%. Non-defense’s first data point is 3.8% and Defense’s first data point is 7.2%. In 1985, Entitlements + Other Mandatory Outlays + Net Interest reached 12.4%. Revenues came in at 17.2% in 1985. In that same year, Entitlements + Other Mandatory Outlays increased to 9.4%. Entitlements were 5.4% in 1985. Non-defense came in at 3.8% and Defense was 5.9% in that year as well. In 2005, Entitlements + Other Mandatory Outlays + Net Interest was 11.7%. In that same year, Revenues were 16.8%. Entitlements + Other Mandatory Outlays were 10.3% in 2005. Entitlements came in at 7.1% in the same year. Non-defense and Defense came in at 3.7% and 3.8%, respectively in 2005. In 2025, Entitlements + Other Mandatory Outlays + Net Interest is expected to be 16.2%. Revenues are expected to be 17.4% in that same year. Entitlements + Other Mandatory Outlays are expected to be 13.5% in 2025. Similarly, in that same year, Entitlements are expected to be 10.4%. In 2053, Entitlements + Other Mandatory Outlays + Net Interest is expected to be 23.1%. In that same year, Revenues are expected to be 19.1%. Entitlements + Other Mandatory Outlays is expected to be 16.4% in 2053 as well. Entitlements are expected to be 14.3% in that same year.
- The knock-on effects, such as on the dollar. Worries about deficits and debt tend to prompt questions over whether the dollar can hang on to its crown as the reserve currency of the world. Yet today, the dollar’s importance is unparalleled in currency trading markets, international trade and banking, and foreign exchange reserves across economies. As an example, the U.S. dollar makes up one side of almost 90% of FX transactions, and it’s used for around half of all trade invoicing. So while history suggests its reign may not be as strong forever as it is today, its position on the throne still looks secure, at least for the next few decades.
In sum:
Fitch’s downgrade calls out the long-term challenges around the large and growing stock of U.S. debt, and at some point those must be reckoned with — but it doesn’t bring new risks or information.
Investment considerations
Maintain a long-run mindset
We understand that you might be nervous. While last week’s news flow doesn’t change our constructive outlook for the next year, it can help to remember your long-term investment plan. Uncertainty and volatility can make navigating the market difficult. But over time, diversified portfolios have been able to smooth the ride, especially through the bad stuff.
This chart shows rolling annualized total returns, from 1950 until 2022, on a 1-year, 5-year rolling, 10-year rolling, and 20-year rolling basis, for stocks, bonds, and 50/50 portfolio. 1-year rolling annualized returns: Stocks: range of 60% to -41% with an average of 12.5% Bonds: range of 39% to -15% with an average of 6.1% 50/50 portfolio: range of 47% to -21% with an average of 9.1% 5-year rolling annualized returns: Stocks: range of 30% to -6% with an average of 11.5% Bonds: range of 22% to 0% with an average of 6.0% 50/50 portfolio: range of 23% to 0% with an average of 8.9% 5-year rolling annualized returns: Stocks: range of 30% to -6% with an average of 11.5% Bonds: range of 22% to 0% with an average of 6.0% 50/50 portfolio: range of 23% to 0% with an average of 8.9% 10-year rolling annualized returns: Stocks: range of 21% to -4% with an average of 11.4% Bonds: range of 15% to 1% with an average of 5.9% 50/50 portfolio: range of 8.8% to 0% with an average of 8.8% 20-year rolling annualized returns: Stocks: range of 18% to 5% with an average of 11.1% Bonds: range of 12% to 2% with an average of 5.8% 50/50 portfolio: range of 14% to 5% with an average of 8.7%
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