Donna Rasile:

Hello and welcome everyone to a new episode of FinTrust Capital Advisors “From the Desk Of”, our podcast about markets, life, and things financial. My name is Donna Rasile, Senior Vice President and Investment Advisor here at FinTrust Capital. I am joined today with our Chief Investment Officer, Allen Gillespie. We are here to discuss the recent downgrade of the US debt rating and what implications that has on the economy and to our investors. So, let’s jump in. Allen, so great to be with you today. I have just a couple of questions for you.

Allen Gillespie:

Sure, glad to be here Donna.

Donna Rasile:

The recent event on August 1^st, whereby Fitch Ratings downgraded the long-term debt from AAA to AA+, has many asking questions such as what is that saying about our government? What is it saying about our economy?

Allen Gillespie:

Sure. The Fitch downgrade, you know, this is the second time the US has been downgraded. S&P undertook a similar action back in 2011. And you know Fitch cited really a deterioration that they expect over the next three years and the fiscal condition of the nation. It cited the high and growing debt burden. Obviously, we’ve been on sort of a spending binge that really predates COVID, but really accelerated both during and post COVID period. And then the erosion of governance, right, particularly when compared to other similar countries. So really those three factors is what led Fitch to downgrade the US to AA+ rating.

Donna Rasile:

OK, given that they have downgraded, do you see other rating agencies following suit? And if so, what would that impact be? And would there be any force selling?

Allen Gillespie:

Yeah, right now because you don’t really cross what’s known as a credit window, I don’t think it leads to force selling. The big one when things drop from say high investment grade to low investment grade or below investment grade, those are really the triggers where from a regulatory perspective. Now, I think we got a glimpse of this in bank capital world with the recent bank crisis. The issue there was sovereign debt had a zero-risk weighting, so the banks weren’t actually holding adequate capital for how much they could move in relation to interest rates. And obviously one of the ways governments default. I mean, ultimately what is a credit rating? It seeks to measure a probability of default, you know, and severity over some length of time and there are various ways to measure that. But the way sovereign defaults play out is a little bit different than a corporate default, because they have the option of printing money. So just, you know, really quickly, just some color on sovereign defaults. They take various forms, so one obviously is what I call a repudiation, right? Those are rare. They do happen. Think of those as when complete governments turn over. Russian Revolution, you got a new government, they say any debts from the prior government “we’re not going to pay”. So, it’s not a case it can’t pay, it’s a case it won’t pay. So anytime you have big political turnover, right, probably not that case. Next option is you can restructure debts, right? That’s another way, sort of defaulted debt gets dealt with and another is obviously inflation, right? And another is deflation, in which case you dial back your spending while productivity sort of takes off. That actually happened in the 1890s. You in essence repay the debt and put it back on better footing. So, the first is “What is a rating?” It’s a probability of default in some sort of cumulative event. We seem to be content to be on a path to inflate, trying to inflate away our debt obligations, which is just a default in another form. But it doesn’t mean the outcome to investors is going to be any less different but the way that plays out in the market is the same. And what I mean by that is if you have, say, $100 and you get a default with 40% severity, right, you get back $0.60 on the dollar, right? But if you experience, you know, inflation at 2% for long enough, eventually if you just stayed in cash, you’re going to have lost 40% of your purchasing power. So, either way they will have taken and not repaid $0.40 of your currency, right? So, the way sovereign defaults play out is very different across time. And then obviously to your question, “other rating agencies”, there is one more major rating agency in the US, which is obviously Mooney’s. But then I think people are forgetting in the case of sovereign debt that China has its own rating agencies as well and they had downgraded previously U.S. debt back during the other episode, which caused a little bit of a political firestorm. But obviously the Chinese Government, Chinese businesses, and foreign businesses, you know, we have a lot of debt held by foreigners and obviously they may or may not listen to domestic rating agencies who they might see as otherwise politically corrupted.

Donna Rasile:

You got it! Yeah, that’s really helpful. I know a lot of our clients, given the interest rate environment and our own treasuries, you know, should there be concerns about those positions in their portfolio?

Allen Gillespie:

You know, obviously the rate, it always has to compensate you for the inflation. So, what does a AA really translate into? You know, if you look historically, say you took a bunch of AA rated bonds and held them with no turnover for 20 years, on average about 2.5% of those will ultimately default and the average loss would be about 40%, you know, on those that that do default. So essentially what you’re saying in the US, and the problem with the math though from an investor’s standpoint means you could go along, and that bond performed very well for 20 years and on the last day it defaults, so you lose 40% of your money on the very last day, right? Or an inflationary environment you’re going to lose 40% incrementally over 20 years. So, I think right now the treasuries are sort of fairly compensating for the inflation risk. But I think what Fitch is pointing to is we do have some governance issues. I think we have some demographic issues where this debt burden is going to continue to grow because of the benefits promised to the Boomers. And that is absorbing more and more. Now it will improve, you know, as a function of demographics. But I believe when we get to that turning point, it will probably manifest itself in much more severe concerns about the sovereign’s ability to deal with it because of the numbers. Healthcare, right? Just think about what’s going to happen to healthcare expenditures as the Boomers age. Most healthcare dollars spent happen in the last year of life and that’s really going to go exponential as all these boomers, you know, who are on government programs ultimately enter that stage of life. And so, your debt burden is really going to rise and there doesn’t seem to be any political will to fix it. So, I think as we move through the decade, I don’t think it’s an immediate problem, a AA, but it is a 20-year problem, and it’s one that when I look at the demographic curves, I think it’s going to probably hit home between ‘28 and ‘32 with was some severity, if I had to guess.

Donna Rasile:

What portfolio positioning as it relates to fixed income markets should one consider, given the situation, how about corporates or other areas within the fixed income market?

Allen Gillespie:

Yeah, I mean, ultimately corporates, you know, are one thing. I mean we saw that during the 2008 crisis. We see that now. There are AAA rated companies. During 2008, there were about 50 global companies whose sovereign debt, I mean, whose “sovereign debt”? They act like countries. They’re about the size of countries, but traded through sovereign debt, right? And really that used to exist if you think pre-World War II, where governments weren’t nearly as stable. Mobile capital frequently had lower interest rates than sovereign capital, right? Because think about this, kings and princes would frequently engage in stupid wars and lose, right? And if you’re on the losing end of a war, right, your ability to pay back debt is low. Whereas the Medici or other families can move their money around the globe, you know, accordingly. And so, in many ways, corporate capital, global corporate capital, can escape the most severe events in a way that a sovereign cannot and so really, the idea of sovereign debt being the highest rated debt is of modern phenomenon, post-World War II phenomenon. That really is not consistent with the full historical track record.

Donna Rasile:

And to that point, what do you think about diversification within fixed income?

Allen Gillespie:

Yeah, I do. In part because I mean the nature of the corporate bond market. People don’t think about how indexes are constructed, so if you go back 30 years ago, the bond indexes had a lot more corporate debt, a lot more mortgage debt. But now because sovereign debt is, you know, we sort of ballooned the federal deficit, sovereign debt makes up a much bigger component. So, in essence if you wanted to have the same bond market exposure that buying the bond market would have been 30 years ago, you would own more corporates than you do today in the mix. So, diversification is always a good idea. Again, I think currently, we probably, I think the rate environment is reflective of the interest rate and inflation risk, you know, for the moment. Now that payments are north of a trillion dollars, I don’t know how long that’s really going to be tolerable for the federal government to keep interest rates up, independent of the inflation environment, because of what it does to their own budget.

Donna Rasile:

So, what I’m hearing is there is more concern about that, than necessarily this downgrade?

Allen Gillespie:

Yeah, I don’t think. The downgrades are just, I think, reflective of where we are and where we’re headed, right? I don’t think it’s an immediate, you know, sort of risk. I mean, AA companies just rarely, short of fraud, rarely does say a AA just absolutely default, right? It’s kind of like, you know, there’s an old saying “How did you go bankrupt?” and the answer is “slowly and then all at once”. Right? It tends to build on itself, but certainly without corrective action, right, there doesn’t seem to be any willingness to repay with any sort of consistency of the money. So, to me, the most likely scenario looks like default through inflation, you know, at the moment.

Donna Rasile:

Allen, anything else you would like to share with our listeners today?

Allen Gillespie:

No, just, I mean, one would be just kind of immediate, right? And I don’t know whether we’ll see that kind of more slow motion. I do think the economy is in better shape versus the last downgrade. I mean, the last downgrade occurred coming out of the ‘08 recession where we had also spent a lot of money, right? As the economy recovered, you’re able to dial that back. But back then, the underlying demographics, I don’t think we’re as constructive, right? Because the Boomers had already passed peak spending. And we really didn’t have enough underlying, whereas now we have the millennials coming along. So, I actually think we could dial back a lot of the federal spending and not have as dramatic impact, but back then it did create a 10 to 15% correction in the equity markets. Maybe the same thing happens, it might be slower, don’t know. But you know, computers love to do actuarial science, and they will certainly dial in on that event. But I do think constructively, we’re a little less dependent on the stimulus and it’s not uncommon to see the fiscal situation deteriorate post-recession, right? But I think that if there’s one thing that’s kind of concerning, a little bit is normally you see it deteriorate because tax revenues go down, spending goes up during recession, is that this time Fitch did it with like a three-year outlook, right? So, we continue to spend without the associated tax revenue. Now it’s not that tax revenue hasn’t rebounded; it has but spending to put in perspective, has gone from about $3.7 trillion a year to north of $6 trillion a year over the last three years with no appetite to even get it back to anything reasonable. So even though tax revenues have strongly rebounded, federal spending is up a lot and just really hasn’t been dialed back in. So that’s really what I think Fitch was concerned about. Normally you sort of get that bulge and then it sort of backs off. We just haven’t seen the backing off of spending programs now.

Donna Rasile:

So, what I’m hearing is it’s a little bit of stay tuned?

Allen Gillespie:

So, it’s a little bit of a stay tuned, but I think it’s an important issue that is going to continue to build and it won’t be the last we’ve heard of it this decade.

Donna Rasile:

Well great. As always Allen, thank you for your time today. It’s always great to get your insights, knowledge, and thought leadership. Thank you all for listening today. We hope you found this podcast to be informative. It is our goal at FinTrust to provide insightful topics to add to your overall client experience. As always, if you have any questions, please feel free to reach out. We are happy to speak with you. We look forward to the next time you join us for “From the Desk Of” podcast.

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