June 24, 2020 | 16:17
Triple-Eh No More
Fitch downgraded Canada’s credit rating from AAA to AA+, somewhat tarnishing what was previously a unanimous AAA rating across the four major rating agencies. This marks the first sub-AAA rating for Canada since 2004 (note that Fitch was the last of the group to upgrade the country to AAA during that period, about two years behind the others). The downgrade comes on a forecast that sees consolidated gross debt-to-GDP jumping to 115% of GDP this year, from 88% of GDP last year, and is based on a pretty downbeat economic forecast (particularly for the recovery). For example, Fitch assumes a 7.1% real GDP contraction in 2020 (versus BMO's -6.0%) and a 3.9% recovery in 2021 (BMO +6.0%).
The market response has been relatively muted, but also masked by a heavy risk-off trading day. Still, the move is symbolic, and raises a number of issues/questions…among them:
Will others follow? It wouldn’t be surprising at all to see, at minimum, some negative outlooks on the remaining AAA ratings. There’s still plenty of uncertainty on the shape of the recovery and fiscal path, particularly beyond this year. We know with confidence that the federal deficit will widen to $250 billion (11% of GDP) or more this fiscal year (fiscal update expected July 8th). See our recent report here. But, the appetite for deficit reduction post-COVID will be a big question mark for some time. At minimum, almost $160 billion of direct support measures should roll off, but we're already seeing measures extended (e.g., CERB) in fear of crippling the recovery.
It's worth keeping in mind that Canada entered this shock in an enviable fiscal position. One reason the loonie didn’t sell off too much might be the fact that investors know that all major developed economies are facing a very uniform shock to their economies and public finances. If Canada was best going in, on a relative basis, maybe they’ll still be best when the dust settles.
Borrowing costs are also still historically low, and GoCs only underperformed in the longer maturities on Wednesday, and even that was partially driven by Finance Minister Morneau musing about extending the maturity profile of federal debt. Bank of Canada buying will also help contain any upside in yields. Note that debt service costs were at a record low relative to revenues when we entered this downturn, with the ratio sitting at 7%. That compares to 15%-to-20% in the early-2000s when Canada was earning its AAAs, and the early-90s peak of nearly 38%.
Will provincial ratings follow? This one is questionable as it’s rare to have a region rated above the sovereign (e.g., British Columbia is still AAA across the board). However, the provinces aren’t shouldering nearly the same COVID burden that the federal government is, with total support measures estimated at about $30 billion. As such, we believe that most provincial deficits will settle in around 3% of GDP, or a quarter of the federal level. Also, the autonomy of the provinces to run fiscal policy and tap credit markets remains one of their greatest strengths.
The Bottom Line: While this particular downgrade shouldn't have a major impact on the market or borrowing costs, it serves a message that Canada is not fiscally immune, and that governments will have plenty of work to do after the pandemic (and necessary support measures) come to pass.