S&P Global Downgrades The US Debt, Again?!

I wish I could say this was an April Fools joke. The sad truth, this headline could cross the news wires any day. As an investment manager working at one of the largest investment firms on Wall Street in 2011, this was a grueling week of market volatility. I vividly remember a version of that headline crossing the news wires on August 5th 2011. It was the first time in United States history that our financial stability and our sovereignty were drawn into question. The reasons cited by S&P Global for their historic downgrade were scrutinized, lambasted, and even completely dismissed. Unfortunately, their analysis led to the all important realization our government was headed down a dangerous path. Fast forward more than a decade later, the rationale presented then has far exceeded S&P Global’s expectations AND presents the question: Is this the year S&P Global Downgrades The US Debt, Again?!

To know whether this is the year for the next downgrade we need to look back at the rationale used to make the historic decision in 2011. Furthermore, we need to assess whether situations have improved or deteriorated further.

Let’s start with a review of a few critical excerpts from their Press Release:

“We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process…

The political brinkmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability…

In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging (ibid)…

When comparing the U.S. to sovereigns with ‘AAA’ long-term ratings that

we view as relevant peers–Canada, France, Germany, and the U.K.–we also observe, based on our base case scenarios for each, that the trajectory of the U.S.’s net public debt is diverging from the others. Including the U.S., we estimate that these five sovereigns will have net general government debt to GDP ratios this year ranging from 34% (Canada) to 80% (the U.K.), with the U.S. debt burden at 74%. By 2015, we project that their net public debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France), with the U.S. debt burden at 79%. However, in contrast with the U.S., we project that the net public debt burdens of these other sovereigns will begin to decline, either before or by 2015…”

At the time of this evaluation, making such an outlandish forecast of the US’s financial stability – and even trajectory – was considered laughable. How could anyone think the United States of America couldn’t pay their debts? While the majority of the ridicule and backlash may have been limited to side rooms, and whispers, across the world, there were a number of prominent people who spoke out.

For example, in a statement to Fox Business Warren Buffett said “doesn’t make sense. … Think about it. The U.S., to my knowledge, owes no money in currency other than the U.S. dollar, which it can print at will. Now if you’re talking about inflation, that’s a different question.” While accurate, if Mr. Buffet only knew what would ensue in the following decade he may not have been so critical. To think today, April 1st, we have reached the point where the US budget deficit has increased almost 80% since 2011, $1 trillion is printed every 100 days, and inflation has remained above the Federal Reserve’s 2% target for over three years – S&P Global’s views in 2011 comes squarely into focus in 2024.

But what did the government, namely the Federal Reserve – the people in charge of printing the money – think at the time of this rating downgrade?

In an article published by the Atlanta Federal Reserve, Gerald Dwyer cites an interesting excerpt from S&P Global’s analysis “”from an estimated 74% of GDP [gross domestic product] by the end of 2011 to 79% in 2015 and 85% by 2021. Even the projected 2015 ratio of sovereign indebtedness is high in relation to those of peer credits and, as noted, would continue to rise under the act’s revised policy settings“. He goes on to state:

“A “monetary score” is part of S&P’s credit rating. Perhaps not surprisingly, S&P’s criteria do not say that a country is rated AAA if a central bank can print money and pay the debt. Instead, a sovereign government receives a monetary score based on, among other things, “the credibility of monetary policy, as measured by inflation trends” (S&P 2011d, p. 31). S&P’s description of this point makes it clear that a lower inflation rate is associated with a higher monetary score. Using S&P’s actual criteria, inflating away debt generates a lower credit rating, not a higher one. This implies that the ability to print money and make nominal payments is not a sufficient criterion for receiving an outstanding credit rating.”

So why is this important now, in 2024?

Well, if we apply the same overarching rationale provided by S&P Global in 2011 to 2024 it becomes pretty compelling that the US Federal Government is ready for its next downgrade. Except this time it will move from AA+ to AA, or worse, AA-. To pay down the hefty amount of debt the United States has to either inflate their way out of debt, by printing more money, leading to much higher inflation – which we know what that does to the economy (2020 – 2024); or the United States has to raise tax revenues enough to make a large enough dent in the public debt. I say raise revenues rather than cut spending because, at the moment, 85% of government spending is allocated to entitlements (i.e. Medicare, Social Security, Health, Income Security), national defense, and interest payments. Therefore, to make any material difference in the national debt Congress has to address the 800 pound gorilla or raise revenues – and neither party wants to touch entitlements.

If that wasn’t bad enough, as a percentage of GDP, the US deficit is expected to reach almost -7%. That may not seem like a lot in absolute terms, but in relative terms we have only operated with a deficit larger than where we are today three times in the last 75 years (2020, 2009, and 1942-1945).

But maybe this time is magically different. Therefore, let’s build the case together and you be the judge if the US Federal Government is due for another downgrade. Just remember, similar to 2011, if the US receives another material downgrade all bonds – across the world – will need to be repriced as riskier since the US Treasury market is generally classified as “risk-free”. Furthermore, if the Treasury market is repriced as more risky so will all US corporate debt which will also negatively impact the stock market. The point being, if you believe the US Federal Government debt should be downgraded again then you ALSO believe the stock and bond markets are in for quite a bumpy ride ahead.

Let’s compare the financial situation at the end of 2011 to now (2012 to 2024) as reported by the World Debt Clock:

US National Debt: $16.3 Trillion / $34.6 trillion
US Budget Deficit: $1.03 trillion / $1.78 trillion
Ratio of Gross Debt To GDP: 104% / 122% (88.2% For Public Debt to GDP)
Political Stand-offs: Yes / Yes
Debt Ceiling Battles: Yes / Yes (It had to be suspended due to the fighting)
US Entitlements Fixed: No / No
US Governance Stable: No / No
Tax Revenues Up or Down: $2.48 trillion / $4.7 trillion

In looking at these factors alone, has the US’s financial situation improved or deteriorated? I have a hard time seeing how anyone can confidentially say “Yes” we have made great strides toward becoming more financially stable. Although, as noted in the S&P Global analysis, maybe the question should be “Has the US financial situation improved compared to Canada, France, Germany, and the UK?” Well let’s see:

Canada –

2024 National Debt: $2.27 trillion
2024 Public Debt To GDP: 128.3%
Political Stand-offs: Yes
Debt Ceiling Battles: Yes
Entitlements Fixed: No
Governance Stable: No

France –

2024 National Debt: $3.68 trillion
2024 Public Debt To GDP: 127.3%
Political Stand-offs: Yes
Debt Ceiling Battles: Yes
Entitlements Fixed: No
Governance Stable: No

Germany –

2024 National Debt: $3.32 trillion
2024 Public Debt To GDP: 79.1%
Political Stand-offs: Yes
Debt Ceiling Battles: Yes
Entitlements Fixed: No
Governance Stable: No

United Kingdom –

2024 National Debt: $3.74 trillion
2024 Public Debt To GDP: 108.3%
Political Stand-offs: Yes
Debt Ceiling Battles: Yes
Entitlements Fixed: No
Governance Stable: No

Ahhh… let’s rejoice as the United States isn’t the worst country, fiscally speaking, amongst its peers. Apparently we remain one of the cleanest dirty shirts in the laundry hamper. And yet, while the United States may be in a better financial position than some of its peers across the world, we have met the “taboo” milestones S&P Global forecasted over a decade ago. This brings us full circle to reason for this article.

In an interview with CNBC, John Chambers – former Chairman of the Sovereign Rating Committee at S&P Global – spoke about the 2011 downgrade saying “Right now the deficit of the general government — which is the federal and the local governments combined — is over 7% of GDP and the government debt is 120% of GDP. At the time, we forecasted that it might get to 100% of GDP, and the government ridiculed us for being too scaremongering…”.

With no clear path forward toward political harmony, reigning in government spending, bringing inflation back to 2% before 2026, – not to mention another financial crisis looming around the corner (i.e. recession, commercial real estate, war) – it’s your turn to decide…

Is it time for S&P Global Ratings to downgrade US debt, again?