An Upgrade, Federally; A Further Shock, Municipally

America's credit rating received a boost today. Standard & Poor's (S&P) revised its credit outlook on U.S. sovereign debt to stable from negative, though it left the actual rating at AA-plus. (In August 2011, the credit-rating agency had lowered the rating from the highest AAA, to AA-plus, the second highest, and reiterated its negative outlook.)  The two other major agencies, Moody's and Fitch, have all along left their ratings at AAA, but also assigned, and still maintain, a negative outlook.

In a world awash with unprecedented annual government budget deficits, and levels of sovereign debt accumulated over decades that in some cases exceed the total value of a country's gross domestic product (Japan's public debt, for example, is equivalent to 250% of its GDP), this credit upgrade is a bit of good news. It reflects a rapidly shrinking U.S. federal budget deficit, from those in each of the past four years that exceeded $1 trillion, to the most recent estimate (from the bi-partisan Congressional Budget Office) of $642 billion in the fiscal year ended September 30, 2013 (see the accompanying chart). Measured as a per cent of GDP, the deficit improvement is considerable, dropping from 10% in 2009, the deepest point of the recession, to the 4% now projected for this fiscal year. The ongoing budget battles since 2011, between Republicans and Democrats in the Congress, have led to several piece-meal deals that managed to reduce the budget deficit through higher taxes and spending cuts. And, at least as importantly, America's economy is growing again, albeit slowly, a potent force as it increases the tax base and hence tax revenues.  

But this good news is of a very short-term nature. There is concern that the improving deficit picture, happening now and forecast by the Congressional Budget Office (CBO) to continue over the next 2-3 years, has virtually stopped bi-partisan talks to reach a 10-year fiscal "grand bargain" under which long-term entitlement spending (Social Security, Medicare and Medicaid) would be set onto a sustainable path. This is why the CBO projections indicate a resumption of increasing deficits beginning as early as 2016. Total federal debt would thus likely remain above 70% of GDP at least over the next decade, compared with an average of 39% over the past 40 years. "Such high and rising debt later in the coming decade would have serious negative consequences", the CBO said. U.S. financial markets apparently agree, barely budging today on the news of the S&P outlook upgrade.

There is additional news of a credit nature, coming this week, pertaining to municipal debt. Detroit's Emergency Financial Manager, Kevyn Orr, is expected to provide an update of the city's financial position, and leaked reports suggest that he will ask bond-holders and pension recipients to accept pennies on the dollar as the only way to avoid a formal declaration of municipal bankruptcy. Orr’s initial report last month found that Detroit’s cash-flow crisis makes it “insolvent” and unable to borrow more money to offset debts being made worse by skipping millions in payments for retiree pensions and health care. Protests are expected in Detroit.