Markets traded lower last week with the S&P 500 falling -2.3% and the US Aggregate bond index falling -0.6%. The S&P 500 had the largest weekly drawdown since March while the bond markets were rattled by rising long-term rates. Investors had a generally tame response to the labor market data (JOLTs, ADP, unemployment) and business activity reports (ISM, factory orders, PMI), but it was the credit rating downgrade on US debt by Fitch on Tuesday that surprised the markets. The positive economic momentum, reduced recession expectations, and anticipated large issuance of new Treasury debt (in combination with the Fitch downgrade) pushed the long end of the curve higher by nearly 20bps – a large weekly move. As a result, longer duration fixed income and growth equities led the market lower last week.
Following the US credit rating downgrade, the Fitch report cited “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” leading to a less certain ability to service US debt. There were quick rebukes from Wall Street and the usual rhetoric from Washington. Republicans pointed at Democratic spending goals whereas Democrats blamed Republican tax cuts and massive stimulus measures during the COVID period. On Wall Street, many pointed out that this move by Fitch was unwarranted and irrelevant given the current economic strength of the US economy and that US debt is the still the safest in the world. For context, when S&P downgraded the US more than a decade ago, the rating change triggered a broad selloff in equities, but boosted Treasuries as investors sought out havens. We will see what the markets price in over the next few weeks, but ultimately, rates are determined by economic activity, labor market progress, real wages, and inflation expectations. In general, these metrics typically matter more to voters more than a credit rating agency or even the current outstanding debt of the US. Still, any indicator pointing to shortfalls in stewardship of the economy could damage public perceptions of government, particularly ahead of an election year. The partisan vindictiveness seen in response to the ratings cut will likely delay any deal addressing long-term fiscal issues. If this scenario plays out, Fitch will probably be proven right in downgrading US credit.
A growing point of concern for S&P and Fitch has been the increasing debt burden on the United States and how that will fare in an environment with higher interest rates. Currently, the US enjoys a significant amount of outstanding debt at very low interest rates; however, as that debt is refinanced at higher rates, the interest expense is expected to grow considerably. A rising interest expense relative to revenues will hinder the government’s ability to spend money elsewhere.
The federal budget is persistently run at a deficit – the US government spends more than they bring in and finance/borrow the difference. Based on the budget below, there is only so much the government can cut to balance the budget without touching ‘mandatory’ spending (Medicare/Medicaid, Social Security, and interest). It seems the US will have to grow or inflate their way out of the current deficit/debt challenges and re-gain a AAA rating from Fitch/S&P.
There were some mixed signals from the labor market this week. The ADP employment data released on Wednesday came in much better than expected (+320k jobs vs +190k expected), but the more closely watched report from the Bureau of Labor Statistics (BLS) on Friday showed jobs increased by +187k, coming up short compared to the +200k jobs expected by economists. Although the report missed expectations, included in the BLS report, wages stayed strong (+4.4%), and the unemployment rate fell to 3.5% (from 3.6%). Finally, record job openings have been an important driver of the Federal Reserve’s aggressive tightening campaign over the last 16 months. The chart below shows the ratio of openings to unemployed people was little changed at 1.6 in June. Still well above pre-pandemic levels.
A quick update on earnings season… another 30%+ of the S&P 500 as measured by market cap reported quarterly results last week and earnings continue to trend better-than-feared. Apple, the largest company in the world, showed slowing fundamental growth in their business this week, but most other companies reported good margins and solid revenues/earnings. Plus, forward guidance from many companies has improved slightly quarter-over-quarter which should support upward analyst revisions in the coming weeks.
Source: Bloomberg, JPM, CBO