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The world is changing! Fitch Ratings downgraded the United States' creditworthiness from triple-A to double-A. The US was once the absolute economic power in the world, and the U.S. dollar was the most desired currency globally; maybe it still is, but cracks are appearing in this fortress. The U.S. could have borrowed money from anyone, and there was never even a sliver of doubt that the country couldn't pay it back. But, credit agencies like Fitch have started to paint a new picture by downgrading the country's creditworthiness.
This seems like a disaster for stock market investors who are used to seeing financial analysts downgrading a stock, resulting in price drops and drama in the market. It's only natural to assume getting downgraded is a disaster for the U.S.
The media certainly make it seems to be a big deal.
But is this downgrade really that bad? Is it a sign of the change in the world economic order? And if so, what are its implications for individual investors and their portfolios?
Let's talk about that.
I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of a series I started a few weeks ago to fundamentally research companies to manage my real-money portfolio. I've already researched Canopy Growth (CGC), Fastly (FSLY), Snap (SNAP) , Shopify (SHOP), Airbnb (ABNB), Unity (U), JD.com (JD), NVIDIA (NVDA) and several others. I also started sharing interesting investing-related stories. The first one was on what happens when the U.S. hit its 2% inflation target. More interesting stories are in the works.
Remember, this content is for education and sharing ideas and not advice to buy or sell any securities.
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Most of you already heard of the Fitch Ratings downgrade of the U.S. But it is not the only credit rating agency that downgraded the U.S. The S&P rating agency downgraded the U.S. back in 2011.
Three big rating agencies in the world rate the creditworthiness of entities such as companies and governments – Moody's Investors Service, S&P, and Fitch Ratings. These three have a 95% global share in the rating market.
The recent downgrade hasn't also come out of the blue. Fitch Ratings has had the U.S. on creditworthiness watch from time to time and has issued a negative outlook in 2011, 2013, 2019, 2020, and earlier in 2023, before the actual downgrade.
The prominent reason for all these downgrade warnings and creditworthiness watches has been the consistent rise in the U.S. debt in relation to the country's GDP and the political standoff and uncertainties in raising the debt ceiling.
Are Credit Agencies Right?
In logical terms, when someone's creditworthiness goes down, it's because there is a higher chance that the person will not be able to make the debt payments. Is there a higher chance for the U.S. not to be able to repay its debt?
It all starts with the government's budgeting process. When the revenue it earns from taxes is insufficient to cover all its expenses on health care, defense, etc., it must borrow money. Typically, the U.S. sell bonds to its citizens and the rest of the world to borrow this money. We know these bonds as Treasuries. As we all know, the U.S. has been borrowing more money year after year, and it keeps hitting the allowed amount of debt and has to increase it through an approval process. If the government doesn't get approval, it won't be able to pay for its expenses, including paying the interest on all the borrowed money over the years.
This gets even more critical when the interest rate is going up. The higher the interest rate the government pays to other countries to borrow money from them, the higher the debt repayment cost, which then requires the government to go through the process of raising the debt ceiling again.
This is where Fitch Ratings insert a concern. It references the political stand-off and resorting to last-minute decisions to increase the debt ceiling as a risk. It's, in a way, true. If these uncertainties around the ability to pay interest scare borrowers from around the world and result in them not wanting to lend money to the U.S. anymore, then, it means the U.S. has lower creditworthiness.
Is the U.S. Creditworthiness Really Lower?
In a way, the downgrade doesn't really matter at this point because no one believes that the U.S. will stop paying its debt, and everyone wants the high yield the U.S. debt generates.
We must discuss one real long-term threat to the U.S.'s global creditworthiness.
What's The Real Threat of Fitch's Downgrade
One of the reasons everyone in the world wants to hold the U.S.'s debt is that it's the world's reserve currency. We hear that all the time. Central banks and major financial institutions hold U.S. dollars for international transactions. When you hold U.S. debt, you get paid interest in dollars, and that's what people want. They want to get paid in U.S. dollars. The long-term threat can be that people won't want and need to hold as much U.S. dollar anymore. That's possible when there is an alternative currency that the central banks would also want to hold.
Every few years, we see an attempt by global players to reduce the U.S. dollar's status as a reserve currency. For example, at the peak of cryptocurrency interest, there was a discussion that central banks hold Bitcoin as a reserve currency.
Recently, there is been talks that China, India, and Russia are settling oil purchases in non-dollar denominations.
These things happen because other countries want to lead the world or at least share the power with the U.S. And every little thing that reduces the U.S. leadership can make a difference in the long run.
A man can only lead when others accept him as a leader. For the U.S., it can only lead the world until others accept it as one. The downgrade in 2011 by S&P didn't have a major impact then, but it gave Fitch the courage to downgrade the U.S. in 2023. One small chipping at the wall of the U.S. creditworthiness can gradually erode the fortress.
So the Fitch downgrade should be a wake-up call to the U.S. to get its act together.
Let's wrap up by talking about the impact on our individual portfolios.
The Credit Downgrade's Impact on the Market
When S&P downgraded the U.S. in 2011, the stock market dropped five to seven percent on the same day. The same happened when Fitch's rating came out on Aug 1st. After the 2011 downgrade, as we know, the U.S. stock market went on several years of upward rally, and nothing really changed because of the downgrade. The same will most likely happen after the Fitch Ratings' downgrade. So there won't be an immediate impact on our portfolios.
But, remember, no one can predict the market's direction, especially the macroeconomic indicators at such a scale as the world's reaction to the U.S.'s creditworthiness downgrade.
I can publish this episode, and despite all our logical arguments, we may have the biggest drop in the stock market the next day that the market opens. You have to always hedge against such risks.
How To Protect Your Portfolio Against the Downgrade's Risk
There are complicated ways that sophisticated professional investors do this. For example, we heard Bill Ackmen, the famous hedge fund manager, explaining his strategy of shorting 30-year U.S. treasuries by buying options. His decision wasn't just due to the downgrade, but he made the Fitch downgrade as one of the reasons to support his decision.
There are other and simpler ways to hedge against big macro factors for individual investors. The easiest way is to invest in countries besides the U.S., especially for those long-term investment accounts. For example, in my 401K account, I allocate 60% to the U.S. overall index fund and 40% to the rest of the world index fund. You may want to consider some sort of hedge in your own long-term investments too.
See you next time!