However, he acknowledges that it may reinforce concerns over the US’s growing budget deficit and debt. While these issues aren’t new, they have been discussed “extensively” for the past few months, and even years, he adds.
On May 16 (US time), the credit rating agency downgraded the US government’s credit rating to “Aa1” from the country’s triple A status over its growing budget deficit and debt. Moody’s is the last of the three major rating agencies to downgrade the US’s credit rating; S&P Global Ratings downgraded the US to “AA+” from “AAA” in August 2011 while Fitch Ratings lowered its rating to “AA+” from “AAA” in August 2023.
The US’s fiscal deficit in the year that began Oct 1, 2024, is already running at US$1.05 trillion ($1.37 trillion), 13% higher y-o-y, Menon points out.
According to Moody’s base case, should the 2017 Tax Cuts and Jobs Act be extended, the move will add around US$4 trillion to the federal fiscal primary deficit over the next decade, excluding interest payments.
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“As a result, we expect federal deficits to widen, reaching nearly 9% of GDP by 2035, up from 6.4% in 2024, driven mainly by increased interest payments on debt, rising entitlement spending and relatively low revenue generation,” Moody’s reasoned. ″We anticipate that the federal debt burden will rise to about 134% of GDP by 2035, compared to 98% in 2024.″
Looking back at previous downgrades
Based on the previous downgrades issued by S&P and Fitch, Menon believes there may be a near-term impact on the markets but with no lasting impact unless US Treasury yields are to increase sharply.
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When S&P downgraded its rating on Aug 5, 2011, US stock indices and global equities based on the MSCI All Country Global Index fell between 5% to 7% on the first trading day as that was the first time in history that the US lost its triple A rating.
However, three to six months later, equities recovered their losses and were “back in the black”, Menon notes.
“Ironically, the price of US Treasuries, which were subject of the downgrade, actually rose as the US dollar appreciated against the Euro and the pound, helped by a flight to safe assets amid concerns about the European debt crisis,” he adds.
During Fitch’s downgrade in 2023, stocks didn’t fall as much, which Menon attributes to the benefit of hindsight from 2011’s downgrade. That said, US and global equities pulled back sharply after US Treasury yields rose significantly three months after from concerns over US inflation.
To this end, the latest downgrade from Moody’s should not “come as a total surprise” considering that the downgrade has been considered since November 2023, when Moody’s lowered its rating outlook for the US to “negative” from “stable”.
Even so, the move will add to growing concerns about the loss of US exceptionalism, making non-US assets more appealing to global investors who have already been shifting their portfolio into other markets like European equities, Menon notes.
While the analyst remains positive over US equities for the time being, volatility will still remain a fixture due to uncertainties over the US’s trade, fiscal and monetary policy as well as Trump’s “erratic rhetoric”, moves which can impact US Treasury yields.
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With this, Menon recommends that investors continue investing in a diversified portfolio and manage risk through a dollar-cost averaging strategy.
“We remain optimistic on equities and currently prefer Europe and Asia ex-Japan (China, Hong Kong, Singapore),” he writes.
The analyst also prefers high quality, investment grade bonds, particularly short-term bonds with one- to three-year maturities as well as medium-term bonds in the three- to seven-year mark. “They are less susceptible to rates volatility and will provide more stability if there is future volatility,” says Menon.
Investors who are already holding on to bonds with longer maturities can continue to keep them as a form of “portfolio insurance” if the risk of a US recession rises again in the future, he adds.
Finally, Menon is positive on gold with a 12-month target of US$3,900.
