Standard & Poor’s puts US AAA on ‘outlook negative’

S&P changed its outlook on its long-term rating of AAA on US Treasuries to negative in response to the upcoming debt ceiling debate and vote in the US congress. The debt ceiling is a congressionally mandated limit on the total public debt the US Treasury can issue. It currently stands at approximately $14.294 trillion dollars and includes off-balance sheet programs, such as Social Security, Medicare and Medicaid (also known as entitlement programs). The current US debt applicable to the debt limit is currently $14.253 trillion.

The debt ceiling was meant as a checks-and-balances approach to maintaining fiscal responsibility, but over the years it has become a means for the minority party to score political points. The debt ceiling has always been raised but there have been temporary government shutdowns and last minute negotiations to avoid a technical default (missed coupon or principal payment of existing debt). Without going into all of the details, we would point out that the US Treasury can operate for several weeks above the debt ceiling before payments must be furloughed. The most significant stop payment would be on the US debt. This would serve as a technical default – a default nonetheless, and, were that to ever actually occur it would reduce foreign investor confidence in the Treasury and the US government.

The upcoming debt ceiling is expected to be breached between the first and second week of May. The Treasury will have less than 8 weeks to manoeuvre above the debt ceiling before the potential for a missed coupon payment becomes reality.

Fiscal outlook and the US federal budget
The CBO estimates the federal deficit will rise by ~$7 trillion from fiscal year 2012-2021 and the debt held by the public will increase to 77% of GDP in 2021. It is broadly understood that a long-term fiscal framework is expected to accompany an increase in the debt ceiling. However, both parties (Republican and Democrat) have taken rather cavalier approaches to handling the debt ceiling issue. The Republican Party and its newly elected fiscal conservative members have threatened to allow a default on the Treasury debt in order to secure fiscal spending concessions as a roadmap to reduce long term deficits. On the other hand, the Democrats’ approach has been a “calling the bluff” on the Republicans as they were unwilling to concede on fiscal austerity without tax increases, since they believe Republicans would not go to such an extreme. This increasing rhetoric and cavalier approach toward the debt ceiling and potential technical default is what has prompted S&P to place the US Treasury on outlook negative.

Fiscal proposals
Both Democrats and Republicans over the past two weeks have put forth two (differing) plans to address the medium and long-term deficit issues. While the accuracy and effectiveness of both proposals remains open-ended we will highlight both parties’ stated fiscal objectives. The Republican approach focuses entirely on spending cuts and reduction in taxes as a growth initiative (~$6 trillion in cuts over 10 years). The Democratic proposal, crafted by the President Obama (~$4 trillion in deficit reduction over 12 years) uses a less aggressive approach to spending reductions and an increase in taxes, particularly for the highest income earners. While, both parties recognize the importance of addressing these issues, the difference in size and execution of these budget measures are significant.

S&P recognized the difference and is looking for compromise, concession and most importantly actual execution of some budgetary reform.

S&P actions
Placing the US Treasury on negative outlook indicates there is a one in three chance of a downgrade over the next two years. The S&P report made it clear that a condition for removal from negative outlook is the passage of the debt ceiling concurrent with a budget measure to address the medium and long-term fiscal imbalances. They also stated that these budgetary measures must begin to be implemented before the next presidential race. S&P is the only rating agency to take such a strong view but has at least brought attention to the looming debt ceiling vote and the necessary budget requirements.

Political outcomes
At this point it is difficult to judge the outcome of the political debate. Fiscal conservatives within the Republican Party may use the negative watch initiative as proof of needed fiscal restraint on spending. On the other hand Democrats may view the increased caution by S&P as limiting the Republicans’ ability to follow through on some of their threats.

In the end we would expect the debt ceiling to be raised and a viable and effective budget measure put in place to address the long run fiscal issues. Unfortunately, it would appear that certain conditions are inevitable: discretionary spending will need to be cut, defence spending will unlikely grow at its current pace and entitlement programs will likely be curtailed at some nominal level. In addition, tax increases will occur and will likely be across all income brackets or in some other mass implementation form. The end result is likely to be some compression in GDP growth at the initial implementation of these changes. However, playing a game of chicken with a technical US default is foolish and hopefully not the outcome of negotiations over the next few months. Foreign investors are key financers of the US debt. Any action which will discourage this base from continuing to support the nation’s debt risks a significant rise in rates (if even temporarily) and could undermine the tepid economic recovery.

Positioning and investing
At Schroders we have been cognizant of the burgeoning fiscal deficits for several years. Once the US government decided to lever its balance sheet while corporate and household entities delevered, we made an active asset allocation decision to underweight US Treasuries in favour of spread product, predominantly corporate bonds (investment grade, as well as high yield for accounts that allow it). The debt ceiling is another facet of the market we have been monitoring closely and have positioned the portfolios defensively to reduce interest rate exposure while these issues are resolved. While we believe the risks lie primarily in the headlines and in short-term movements, the increased partisan rhetoric has made the probability of a technical default a non-zero event. In our eligible accounts we have layered into some out-of-the-money put options which would benefit if yields spiked higher. However, we strongly believe the risks surrounding the large deficits and ballooning debts facing the US are likely to play out over several years and at the margin keep rates higher (through increased risk/term premium) and the yield curve steeper than is typical during various points in the cycle. The recent action by S&P does not warrant a sharp sell-off in rates but is likely to add to rate volatility in the near-term as the political rhetoric in a very public forum increase headline risk.

Conclusion
At the end of the day, the S&P negative outlook announcement was about increased rhetoric out of Washington and an effort to discourage a technical default and more empty political promises on fiscal responsibility. The US has the largest taxpayer base in the world and its GDP is almost as large as the GDP of all other AAA-rated sovereign combined. It has the ability to address its long-term deficit problems, but what is needed now is the willingness to do so.

Perhaps with the threat of actual rating agency downgrades, Congress and the Administration will be able to find the willpower to make tough choices and begin to implement budgets that will put US policy on a sustainable course of fiscal responsibility.

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