19 May 2025, 09:48 UTC
Chief Investment Office GWM
Investment Research
US downgraded: End of AAA
era
UBS House View - Daily US
Solita Marcelli, GWM Chief Investment Officer Americas, UBS Financial Services Inc. (UBS FS)
Mark Haefele, Global Wealth Management Chief Investment Officer, UBS Switzerland AG
Jason Draho, Head of Asset Allocation, CIO Americas, UBS Financial Services Inc. (UBS FS)
Jon Gordon, Strategist, UBS AG Hong Kong Branch
Kiran Ganesh, Strategist, UBS AG London Branch
From the studio What to watch: 20 May 2025
Video: CIO's Sundeep Gantori on what's next for tech following the • Reserve Bank of Australia rate decision
recent AI deals (2:13)
Video: CIO's Kelvin Tay on the impact of the trade war and asset • Various Fed and ECB speakers
allocation strategies (02:01) • G7 finance ministers and central
bankers meeting in Canada
Thought of the day
What happened?
Credit ratings agency Moody’s downgraded the US sovereign credit rating
by one notch on Friday to Aa1, citing continued growth in the national
debt and rising debt servicing costs amid still-high interest rates. With this
latest action, the US government has now lost its last remaining AAA rating
from a major agency; S&P downgraded the US in 2011, and Fitch followed
in 2023.
The downgrade came shortly after the House Budget Committee failed to
advance President Trump’s “One, Big, Beautiful Bill” to extend the 2017
tax cuts, reflecting ongoing divisions within the Republican majority over
spending and deficit reduction. Late Sunday, changes to appease fiscal
concerns saw the tax bill advance through the committee along party lines,
setting up potential passage in the House later this week.
At the time of writing, S&P 500 futures were 1.2% lower, and the 10-year
US Treasury yield is up 9 basis points to around 4.53% at print.
What do we think?
The move should not come as a surprise. The federal government
is running a budget deficit in excess of USD 2 trillion per year, even
after a period of strong economic growth and low unemployment, and
net interest costs now absorb 18% of tax revenues. But while the US
debt trajectory has been worsening and is the reason for the Moody’s
downgrade, this is already well known by investors.
Significant selling of US Treasuries is unlikely, in our view. While
yields may move 10-15bps higher in the short term, as seen after the 2023
This report has been prepared by UBS Financial Services Inc. (UBS FS), UBS Switzerland AG, UBS AG Hong Kong Branch,
UBS AG London Branch. Please see important disclaimers and disclosures at the end of the document.
Daily US
Fitch downgrade, the Moody’s move is unlikely to trigger significant selling
or changes in collateral haircuts, in our view. Most investment mandates
do not require AAA ratings for US Treasuries, and central banks continue to
value the Treasury market for its exceptionally deep liquidity.
The US has very high credit quality, in our view, and aside from cash,
US Treasuries remain the lowest-risk and lowest-yielding USD asset. The
strength of US capital markets, the dollar’s reserve currency status, and
the significant wealth held by US households mean that the US’s ability to
repay debt is not in question, in our view. Academic research also shows
that for countries with monetary sovereignty, rating changes have little
lasting impact on short-term bond yields.
Credit downgrades are less politically costly in the US than you
might think. The first US downgrade in 2011 was unexpected and
triggered significant bipartisan consternation. But it ultimately resulted in
few lasting financial or political repercussions. The 2023 Fitch downgrade
was largely shrugged off by policymakers. The 2025 Moody’s downgrade
may be used as a political tool in near-term budget negotiations,
particularly among lawmakers who believe that the current "One, Big,
Beautiful Bill" does not do enough to shrink the deficit, but we think it is
unlikely to alter the overall trajectory of US fiscal policy.
Equity investors are focused elsewhere. With Moody’s the third credit
ratings agency to downgrade the US, we believe that the shock factor
for investors has likely faded, and we would expect a more muted equity
market response to Friday’s downgrade. In recent weeks, global investors
have been more focused on effective US tariff rates, which we see settling
in the 15% region—a headwind to growth but not enough to cause a
recession, in our view. While budget negotiations and deficit implications
may begin to have an increasing impact on markets in the weeks ahead,
we do not think that the credit rating downgrade in itself will be a major
focus for equity markets.
How to invest?
Overall, we view this latest credit action as a headline risk rather than a
fundamental shift for markets. We would also expect the Federal Reserve
to step in if there were a disorderly or unsustainable increase in bond yields.
So while the downgrade may lean against some recent "good news"
momentum, we do not expect it to have a major direct impact on financial
markets.
Against this backdrop, we make several investment recommendations:
Seek durable income. While there is a risk that bond yields could rise
further in the days and weeks ahead in response to the downgrade, and in
anticipation of higher US fiscal deficits, we believe current (or higher) yield
levels offer an opportunity for investors to lock in durable portfolio income.
Our preference remains for medium-tenor USD bonds of around five years,
but depending on the market reaction in longer-term yields, additional
investment opportunities may emerge in the days ahead. We expect
Treasury yields to fall into year-end and believe high-quality government
and investment grade bonds remain attractive for diversification and
income.
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Phase into equities. We recently cut our Attractive rating on US equities
to Neutral, following the strong recent rally. However, our current Neutral
rating on US equities should not be mistaken for a bearish view, and we
continue to recommend a full strategic allocation. The recent earnings
season has demonstrated the strength in structural AI earnings trends,
we expect US stocks to move higher over the next 12 months, and we
maintain our sector-level Attractive ratings on communications services,
information technology, health care, and utilities. We also maintain strong
conviction in the long-term potential of our Transformational Innovation
Opportunity themes of Artificial intelligence, Power and resources, and
Longevity.
Sell dollar rallies. The dollar has consolidated in recent weeks, following
a spell of significant weakness in the immediate aftermath of "Liberation
Day." We believe that this provides an opportunity for investors with
excess USD cash, or international investors with unhedged exposure to US
assets, to reduce their exposure to the US dollar. Over the longer term, we
believe the trend of international diversification could lead to further dollar
weakness, and particularly if the Federal Reserve begins to play a more
active role intervening in bond markets amid high fiscal deficits.
Navigate political risks. Gold has reaffirmed its value as a hedge over
the past year, and we continue to see its value as a longer-term portfolio
hedge against downside scenarios. Over the long term, a weaker US dollar,
persistent geopolitical pressures, and declining real interest rates should all
support prices. We think a mid-single-digit percentage allocation to gold
within a broadly diversified portfolio is appropriate for investors looking to
manage political risks. We also see hedge funds as valuable diversifiers—
whether through global-macro trading, market-neutral equity strategies,
or agile multi-strategy platforms—capable of cushioning drawdowns when
traditional exposures misalign. Amid geopolitical uncertainty, mounting
fiscal pressures and shifting monetary regimes, they can dynamically adjust
positions, judiciously deploy leverage, and hedge key risks. While careful
attention to manager selection, liquidity terms, and incentive alignment is
essential, a modest allocation to select hedge funds can enhance portfolio
resilience and smooth overall return outcomes.
Caught our attention
EU-US trade talks inch forward. Following the US-China de-escalation
earlier this month, markets have been watching for positive signals on
US-Europe progress. EU Commission President Ursula von der Leyen and
Italian PM Giorgia Meloni meet with US Vice President JD Vance for talks
this weekend. Prior to the meeting, Von der Leyen expressed confidence in
reaching a trade deal, but cautioned that “the devil is in the details.” Vance
described the meeting as “the beginning of long-term trade negotiations,”
according to Reuters. President Trump’s 90-day postponement of new
“reciprocal” tariffs has eased some concerns over trade, but US levies
remain much higher than a month ago.
Our view: Trade tensions have dominated markets in recent weeks, so
any progress should help further improve sentiment. We remain less
concerned about direct tariff impacts on European companies and are
more focused on the risk of a broader global economic slowdown. Our
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base case expectation is for the US effective tariff rate to settle near 15%.
Our scenarios suggest the risk-reward is balanced for European equities
at current levels, and we continue to recommend selective exposure to
European equities through our “Six ways to invest in Europe” theme. We
see better risk/reward in Eurozone small- and mid-caps, given their higher
domestic focus, low valuations, and the potential for rate cuts to cushion
slower growth. At the sector level, we prefer defensives with limited tariff
risk, such as utilities and real estate, as well as IT and industrials for their
long-term opportunities.
US consumer sentiment dips to second lowest reading. Consumer
sentiment deteriorated in early May, with the University of Michigan's
sentiment index falling to 50.8—its second-lowest reading on record.
Nearly 75% of respondents cited concerns over tariffs, highlighting
how trade policy remains a concern for US households. Inflation
expectations surged, with year-ahead views jumping to 7.3% and long-
term expectations rising to 4.6%, both reflecting the highest levels since
1981. Additionally, views on current personal finances dropped to the
weakest level since 2009, and the expectations index slid to 46.5, an
almost 45-year low. Despite this, buying conditions for large household
goods improved slightly, suggesting that consumers may be concerned but
are not yet pulling back spending in a broad way.
Our view: While consumer sentiment has steadily deteriorated in recent
months, the sharp decline hasn't yet translated into a slowdown in hard
economic data. Retail sales are still positive, the labor market remains
resilient, and inflation has surprised to the downside. Additionally, the
Atlanta Fed's GDPNow estimate for second quarter growth currently
stands at 2.5%, revised up from 2.3% earlier this month. However, the
inflationary effects of tariffs may become more apparent in the coming
months, particularly as inventories stockpiled ahead of policy changes
begin to unwind, posing a risk to both inflation and growth. Against this
backdrop, we expect GDP growth to slow to around 1.5% in 2025, down
from 2.8% in 2024, and our base case calls for 100 basis points of Fed rate
cuts starting in September. We continue to recommend seeking durable
income in quality bonds.
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