The Nation’s Debt was Downgraded. Here’s What that Means for You.

Usually, the Employment Situation report is the biggest story on the first Friday of the month. Internally, we call this economic release “the granddaddy of them all,” and pore over the underlying data to determine how it compares to the headlines. They don’t always go hand in hand.

However, today they mostly did.

According to the Bureau of Labor Statistics (BLS), the U.S. economy created 187K net, new payroll jobs in July 2023. While still a decent number, it has been trending a little downwards over the last few months. This is completely understandable given the job creation over the last 2.5 years.

All told, it was a decent report. Trust me, no one is going to remember it in a couple of quarters. That isn’t a bad thing.

As a result, and somewhat unusual, the Employment Situation release isn’t actually the top economic headline for this week. No, that would be Fitch Ratings downgrading U.S. Treasury debt one notch from its highest rating of AAA to AA+.

If this had been a normal corporate issuer, a downgrade of this magnitude might cause a ripple in the markets. However, it wasn’t a normal issuer. It was the U.S. Treasury, the biggest issuer of sovereign debt, any debt for that matter, in the world. Investors buy Treasury securities during geopolitical and/or market distress due to their liquidity and perceived safety.

So, what was Fitch Ratings telling the markets? Why was it doing this now?

If you get most of your economic news from standard networks, you probably got a politicized explanation of why this happened. There was no shortage of finger pointing and name calling.

“It was because of the Democrats! No, the Republicans are at fault!”

Fitch might argue they are both right.

Here is what the ratings agency wrote in its “rating action commentary” as key ratings drivers:

“Ratings Downgrade: The rating downgrade of the United States 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 ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.

Erosion of Governance: 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.”

A tight recap:

• Expected fiscal deterioration over the next three years?
• Steady deterioration in standards of governance over the last 20 years?
• The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management?
• Only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population?

That is a heavy paragraph, isn’t it?

Should U.S. investors be concerned about an economic Armageddon? The quick answer is no, at least not due to this one downgrade.

Here’s why:

1. First, the United States borrows in its own currency. As a result, the U.S. Treasury will never involuntarily default on its debt due to its ability to physically print money. Period.
2. Second, until a better option is available, the U.S. dollar will remain the world’s primary reserve currency for the foreseeable future.
3. Third, the U.S. Treasury market is arguably the most liquid and transparent in the world. Because of this, it serves as a ‘flight to quality’ during periods of geopolitical and economic distress.

For these reasons, you could sort of blow off Fitch Ratings if you want. AAA or AA+? It really doesn’t matter in the short-term, and any number of analysts have said the same thing.

However, it does matter because Fitch is right. Even if we might not want to admit it, it is.

You need to look no further than the Administration’s proposed and estimated budget(s) for the next decade. If you click on the link, please go to pages 142 and 143. It is all there in black and white.

If you go to the far right-hand side of the table and go about three-quarters of the way down, you will see the number 19,912. This is the estimated, accumulated increase in our nation’s debt for the years 2024-2033. Oh yeah, that reported number is in billions, which means the White House is predicting an additional $20 trillion in deficit spending.

Why, you ask? Because the $60.5 trillion in revenue that Washington thinks it is going to collect won’t be enough.

So where does it all go?

Over the next decade, Social Security, Medicare, Medicaid, other mandatory programs and net interest will effectively consume everything. Congress could eliminate all discretionary expenditures, including defense, and just barely break even for the entire decade.

However, is eliminating the defense budget really feasible? With the situation in Eastern Europe and bellicose China? Nope. Should we get rid of the daily functioning of the Federal government in order to balance the budget? Not hardly.

So, what is to happen?

1. First, we pretty much have to forget about meaningful fiscal stimuli out of Washington for an extended period of time. This means the G (government expenditures) component of the Gross Domestic Product (GDP) equation will probably be non-existent, in aggregate.
   • Basically, we simply have to quit looking for Washington to bail out the economy at every bump in the road.
2. Second, there is no way around it, the debt service will soak up even more taxpayer dollars. This will be incredibly frustrating for John Doe, and the source of much resentment.
   • Trust me, this will be a problem in the media.
3. Third, we should expect some changes to Social Security, Medicare and Medicaid, as well as fewer mandatory programs. Congress will likely raise payroll taxes and explore means-based payments. Further, it is hard to imagine the powers that be allowing the current estate tax laws to continue.
   • So, be sure to talk to your financial advisor, lawyer and/or CPA about hiding what you can from the IRS before the end of 2025.
4. Fourth, unless the Federal Reserve gobbles up most of the new issuance (of debt), investors should anticipate interest rates moving and/or staying higher. Unless there is a global conflagration, don’t expect the 10-Year U.S. Treasury to yield less than 2% for, well, ever. It is just basic supply and demand.
5. Fifth, the temptation to raise marginal tax rates is going to be overwhelming.

All told, it is impossible to imagine an additional $20 trillion in accumulated U.S. Treasury debt not having a detrimental impact on economic growth. What with little room for fiscal policy, much higher debt service, reduction in entitlements programs, the sheer supply driving up interest rates and higher taxes? That is essentially the recipe for slower growth.

Isn’t that depressing? Indeed, but it also doesn’t have to happen. Washington can be more fiscally responsible and efficient with our money. We just have to demand it, and be willing to accept a little sacrifice. If not sacrifice, then perhaps not as much largesse.

Whew.

In the end, that 187K net, new payroll number was pretty nice this morning. At least it wasn’t bad. However, it pales next to that $20 trillion number the White House is predicting for the next ten years and Fitch Ratings warned us about this week.

Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.

John Norris

Chief Economist

 

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