The latest event that has shaken the markets worldwide is the downgrade of the sovereign rating of the United States by Fitch Ratings earlier this week.

Indian stocks fell, the rupee plunged, and the bond yields rose, all in keeping with the trend seen in global markets as the news spurred a “risk-off” sentiment globally.

What does this mean for the Indian markets in the long run?

The Indian market will likely bounce back after it is done with the knee-jerk reaction to the news.

Surprise Downgrade

Fitch Ratings downgraded the US government’s credit rating to AA+ from AAA, the first downgrade in over a decade. It joins Standard & Poor’s, which has had a AA+ rating for the US from 2011 since downgrading it for reasons almost similar to Fitch's.

Only Moody’s now has the highest rating for the US.

Fitch has said it expects fiscal deterioration over the next three years.

“A high and growing general government debt burden, and the erosion of governance relative to AA and AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions," Fitch said.

The general government deficit is to rise to 6.3% of GDP in 2023 from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden, Fitch said. For 2024, the agency sees the deficit at 6.6% and expects it to widen further to 6.9% in 2025.

The rating agency said the interest-to-revenue ratio is expected to reach 10% by 2025. The median ratio for AA-rated countries is 2.8%. AAA-rated countries have a ratio of 1%.

To that extent, US ratings should have been downgraded long ago.

Fitch also said the US economy could slip into a "mild recession" in the fourth quarter of 2023 due to tighter credit conditions, weakening business investment, and a slowdown in consumption.

Debt Standoff

The repeated political standoff over the debt ceiling particularly troubles the rating agency. The rating downgrade comes weeks after the US administration and Republicans sparred over raising the debt ceiling, barely preventing a US debt default.

A law dating back to 1917 that puts a monetary ceiling on government borrowing often puts both political parties at the loggerheads. The one this year was intense.

“The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch said.

The rating agency had warned of a rating review in the middle of the standoff between the Biden government and the Republicans. After the downgrade, the Democrats blamed the Republicans for holding up the debt ceiling increase, and the members of the Grand Old Party blamed the president for fiscal profligacy.

Fitch has come in for criticism from the US government and some economists, whereas the broader market tended to believe it will be business as usual.

Treasury Secretary Janet Yellen has said Fitch’s decision was unwarranted.

"Fitch's decision is puzzling in light of the economic strength we see in the United States. I strongly disagree with Fitch's decision, and I believe it is entirely unwarranted," Yellen said.

Yallen says more than debt-to-GDP, the interest burden, when adjusted for inflation, is a better indicator of fiscal health.

Many other economists said Fitch’s main criterion for the downgrade, the economy's health and debt-to-GDP ratio, was improving; hence, they were puzzled by the downgrade. According to a Bloomberg report, Paul Krugman has said the story is more about Fitch than the US’s solvency.

The US remains in the AAA zone for the markets, and a few notches here and there should not matter to them.

Fitch, on the other hand, has said the rating downgrade is about their agency’s lack of confidence in the US government’s ability to stem the fiscal deterioration by building consensus and its poor metrics when compared with peers. It has said the downgrade was not particularly about the health of the economy.

Market Bounceback

Even the S&P’s downgrade of the US over a decade ago had limited impact on the markets.

Counter-intuitively, bonds had fared better due to their safe-haven appeal, which is bound to happen this time too. The bond yields seem to have risen this week for a different reason – a higher-than-expected supply of bonds from the US government.

Most investors will have no option but to keep chasing US bonds and other US assets as the economy has been resilient to massive doses of interest rate increases by the US Federal Reserve.

Indian markets have reacted to the Fitch downgrade of the US economy, which experts say is more of a trigger for profit-taking. In the equity market, the developments around the US ratings will nudge the investors towards more quality stock picks even as a multi-year upcycle is expected.

No surprise then that Morgan Stanley has upgraded India to overweight.