Key Points

• The U.S. credit rating downgrade from 'AAA' to 'AA+' by Fitch reflects concerns over fiscal management and has profound implications for investors.
• Despite initial market stability, potential future downgrades could cause further instability and reputational damage to the U.S.
• Australia's robust economy, AAA credit rating, and burgeoning private debt market present compelling investment alternatives, particularly in light of the U.S.'s downgrade.

For decades, the United States of America stood at the head of the class, a symbol of financial solidity, consistently achieving AAA ratings from the leading credit rating agencies.

However, the world's largest and safest ‌economy grew complacent.

In our June insight piece, we foreshadowed this report card, and it has now become a reality: Fitch Ratings has downgraded the United States of America's Long-Term Foreign-Currency Issuer Default Rating (IDR) from 'AAA' to 'AA+'.

The downgrade isn't just a mark on paper. The implications of this downgrade for the U.S. economy and investors are profound. In this article, we'll unravel these ramifications and explore alternatives for those who invest in the States.

But first, let's delve into why Fitch decided to grade the U.S. down.

What led to the U.S. falling grades

The recent downgrade of the U.S. credit rating from 'AAA' to 'AA+' reflects multiple concerns about the country's fiscal management and economic outlook.

Here are the specific reasons:

Erosion of governance:

Fitch highlights a 20-year decline in governance standards, especially in fiscal matters. The repeated debt-ceiling standoffs, a medium-term fiscal framework and a complex budgeting process have eroded confidence in government fiscal management.

Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an ageing population.

Rising general government deficits:

Fitch expects the general government (GG) deficit to rise to 6.3% of GDP in 2023 from 3.7% in 2022, reflecting weaker federal revenues and new spending initiatives.

General government debt to rise:

Fitch projects the GG debt-to-GDP ratio will reach 118.4% by 2025, a marked increase from the pre-pandemic 2019 level of 100.1%.

Medium-term fiscal challenges unaddressed:

The Congressional Budget Office (CBO) warns that challenges like higher interest rates and rising debt stock remain unaddressed. The CBO projects that interest costs will double by 2033 to 3.6% of GDP.

Risk of recession:

Fitch projects a mild recession in 4Q23 and 1Q24. Annual real GDP growth is expected to slow to 1.2% this year from 2.1% in 2022.

Fed tightening:

The Federal Reserve has raised interest rates three times in 2023 by 25 basis points each time, and expects one more hike. Core PCE inflation remains high at 4.1% year-over-year.

What does this mean for the U.S. economy and investors that traditionally see the states as a safe haven?

The ripple effect of the U.S. downgrade

A downgrade of the U.S. credit rating is not without precedent. In 2011, during a very tense debt ceiling standoff, Standard and Poor’s downgraded the U.S. for the first time in history.

Following the downgrade, the Standard and Poor's 500 experienced a sharp decline of 6.5% on the first trading day. This initiated the markets' most turbulent week since the 2008 global financial crisis, and the stocks required a further six months to return to their previous highs.

However, the current market reaction has been more restrained, and U.S. Treasuries have remained steady.

One of the reasons is that "the downgrade contains no new fiscal information” as pointed out by Goldman Sachs.

​After all, the country's sharp political divide, which has greatly contributed to Fitch's rating, has been evident for years now, without any meaningful consequences in the markets.

For now, the U.S. dollar's status as the leading global reserve currency is undeterred. Investment in U.S. government debt continues to be a common practice among central banks, pension funds, and other significant global investors.

Still, tangible effects are emerging:

1. Market instability

Though immediate consequences are minimal, experts caution there might be further negative credit ratings in store for the States.

Lawrence Gillum, Chief Fixed Income Strategist for LPL Financial, noted in a recent report that "until the U.S. government gets its fiscal house in order, we're likely going to see additional downgrades."

Further downgrades could erode long-term faith in U.S. debt and destabilise markets.

2. Reputational damage

The U.S. has taken a reputational hit, as evidenced by strong criticism from financial leaders like U.S. Treasury Secretary Janet Yellen.

No longer one of the top achievers, the U.S. is set apart from just nine nations that continue to hold the highest ratings from all three principal agencies: Australia, Denmark, Germany, Luxembourg, the Netherlands, Norway, Singapore, Sweden, and Switzerland.

3. Increase in U.S. borrowing cost

The perceived elevated risk of default may lead to a rise in the country's borrowing expenses. This could cause the U.S. government to incur additional interest on newly issued debt, thereby intensifying the overall debt load.

At present, the government is responsible for close to $1 trillion solely in interest payments, which equates to approximately one-third of its total tax revenue. In conjunction with this, the Treasury Department has recently declared it will issue more than $1 trillion in fresh debt during the upcoming third quarter.

3. Currency devaluation 

A reduced credit rating may prompt foreign investors to sell off their holdings, leading to increased currency supply and a potential devaluation of the U.S. dollar.

4. Changes in funds strategies

Several pension and investment funds are governed by regulations that allow them to retain only investments with elevated credit ratings. Should the rating of a specific city or state decline excessively, these funds would be forced to sell any holdings of those bonds. 

Australia: The overachiever in the global classroom

While the once top-of-the-class U.S. was resting on its laurel, the pupil from the back of the class, Australia, was quietly overachieving beyond all expectations.

Australia’s AAA Rating

The Albanese Government in Australia has recently been commended by Fitch Ratings, affirming the nation's AAA credit rating. 

Fitch's endorsement highlights Australia's outperformance of financial expectations and applauds the government's commitment to prudent fiscal management. In their statement, they specifically lauded the efforts to save revenue windfalls over the next five years and address structural pressures on the budget.

Through prioritising the return of revenue upgrades to the budget, Australia projects to save about $83 billion in interest costs over the next 12 years.

The budget is even on track to return to surplus in 2022-23, ahead of many advanced economies.

Australia is one of only nine countries rated AAA by all three major credit rating agencies. This elite status, first achieved under the last Labor Government, allows Australia to access funds at lower rates, fostering an optimal environment for investment and growth. 

Investors worldwide are taking note of Australia as a dependable place to invest.

Australian private debt market

Specifically, the Australian private debt market offers compelling opportunities for investors seeking yield.

Private debt loans generate around double digit cash yield, due to their complexity and illiquidity premiums.

As Young Jo Bae, Asset Consultant at JANA, notes: “The most attractive thing is that private debt offers equity-like returns with materially lower volatility.”

According to Ernst and Young the private debt market in Australia is growing at an impressive rate of 21% year on year. As this market continues to grow, so are the potential opportunities for higher yields, making Australia an attractive playground for investors.

Investing in Australia

FC Capital enables investors to leverage the opportunities offered by the Australian private debt market.

We work closely with our clients to navigate diverse investment opportunities in secured senior, junior and unitranche debt. These strategies are carefully chosen to compose a well-rounded and profitable investment portfolio.

Get in touch for a confidential discussion about your investment options.