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Issue 44: US Credit Gets a Downgrade

August 7, 2023

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This Week’s Highlights

  • What to make of US credit rating cut?
    Fitch’s downgrade of US debt from AAA to AA+ shocked the market. We don’t see the rating cut itself having a big impact, but it does reflect growing concern about America’s fiscal position and a large supply of Treasuries hitting the market that we do believe will push up long-term yields in the months ahead.
  • Jobs strength moderating, still too tight
    Data last week from the US Bureau of Labor Statistics showed signs a year of aggressive Fed hikes might finally at least have started to cool the US labor market. Even so, we suspect wage growth is too high and unemployment too low for the Fed to be satisfied with easing any time soon.
  • Earnings season update
    Amazon won last Thursday’s earnings showdown with Apple, as weakening iPhone sales continue to drag on the world’s most valuable company. Surveying the 84% of firms already reporting, we find that despite a higher-than-average rate of beats, the aggregate Q2 earnings decline speaks to a softening economy.

US Credit Gets a Downgrade

Fitch cuts US debt rating from AAA to AA+
Last Tuesday, Fitch Ratings hit the Treasury with a downgrade on its US debt, from AAA to AA+, two months after a political standoff over America’s debt ceiling put it on the brink of sovereign default. In a rather scathing review of the US as a borrower, Fitch stated that the downgrade reflects an “erosion of governance” over the past two decades—reflected in the now-perennial debt ceiling drama on Capitol Hill—and “fiscal deterioration” as general government deficits continue to swell. While the ratings agency had placed the nation’s rating on a negative watch amidst the debt ceiling crisis in late-May, the move to actually downgrade that rating came as a bit of a surprise on Tuesday and sent a shockwave across the market. The benchmark 10-year Treasury yield rose to a nine-month high before pulling back, but drifted up over the remainder of the week, while the S&P 500 finished downgrade day with a -1.4% loss.


Learning from past threats to America’s rating
Such a ratings cut is not unprecedented. As mentioned, the US was already on a negative watch by Fitch, and the same ratings agency had put the Treasury on notice in 2011, 2013, and 2020, assigning a negative outlook to America’s AAA rating in each instance based on some combination of concern over debt ceiling brinkmanship and recognition of the country’s ballooning national debt. Moody’s had likewise threatened a downgrade during 2011, and Standard & Poor’s (S&P)—who rounds out the “big three” credit rating agencies in the US—famously went through with a downgrade that year, cutting its rating from AAA to AA+, citing unsustainable fiscal policies and policymaking instability as leading to this downgrade, the only other time in history that the US has ever had its rating cut. In response to that downgrade, the S&P 500 suffered a single-day decline of nearly 7%, though Treasury yields actually decreased, paradoxically, as the move prompted a flight to safety and investors piled into US government bonds. Of course, the stock market recovered its losses in a matter of days and Treasury yields bounced along but trended lower through the rest of the decade.

Figure 1 Congressional Budget Office Keeps Pushing Forecasts

What impact will this downgrade have?
The general consensus among strategists has been that Fitch’s rating cut, like the S&P downgrade over a decade ago, will have a limited effect on markets outside of the initial shock experienced last week. Why is that? For one thing, US Treasuries are an asset class unto themselves and, barring risk of an actual default, those holding US government debt typically have much more important considerations than the bonds’ credit rating. Just as witnessed back in 2011, there is unlikely to be significant forced selling as a result of the downgrade; indeed, in many cases, investment mandates stipulating what can and can’t be held refer to ‘US Treasuries’ as opposed to ‘AAA-rated sovereign debt’, carving out a special status for US government bonds that is unlikely to be threatened by Fitch’s cut. Despite the downgrade not causing major problems, in our view it is still symptomatic of underlying issues—the expanding national debt chief among them—that we expect will push long-term yields higher. Along those lines, we have been arguing for some time that as the Treasury shifts from issuing bills to selling longer-term bonds, 10-year yields should rise as that additional supply hits a market worried about the same issues Fitch mentioned in their report.

Last Week’s US Labor Stats

Jobs are resilient, but indications of cooling
Some of the biggest items on the US economic calendar last week were reports on the labor market: red hot for the better part of the last three years, and part of what’s been so troubling to the Fed as it tries to get inflation under control. July marked the 31st consecutive month of increases in US employment, though growth in the labor market did show signs of moderating. According to the US Bureau of Labor Statistics (BLS), nonfarm payrolls ticked up by 187,000 jobs—still robust, but a far cry from the average increase of 312,000 jobs over the prior twelve months. Growth for the month was driven by higher employment in service industries, still rebounding from a big hit during the pandemic, with the health care sector contributing more than half of the increase in payrolls in July, and hiring also showing strength within the financial and construction sectors. Signs of cooling were more evident in a continued decline in temporary help services, a slight decrease in average hours worked, and deceleration within sectors like manufacturing and transportation/warehousing that were key drivers of the post-pandemic labor market recovery.


Labor market is still too tight to justify easing
Still, when we say “cooling,” we’re only talking about a modest slowing of growth, not a Fed-induced reversal in labor market strength, as can be readily seen in longer-term stats on the US job market. As the chart below illustrates, the climb in payrolls since massive job losses during the initial shock of COVID has only seen a marginal reduction in slope since the Fed began hiking rates, while unemployment continues to hover near historic lows. Indeed, the unemployment rate unexpectedly fell to 3.5% in July, and wage growth came in slightly above economists’ consensus, rising 0.4% since June, amounting to a 4.4% year-over-year rise: twice as high as what the Fed considers a comfortable level of wage inflation. All in all, we see labor market stats over the last few months as a mixed bag, hinting at the beginnings of a slowdown, but hardly justifying optimism that the Fed will soon reverse course on its tightening campaign. From a policy perspective, we read last week’s jobs data as positive in the sense that the numbers give Fed chair Powell and his colleagues on the FOMC something to think about ahead of their September meeting, with attention now squarely shifting to this week’s CPI release.

Figure 2 US Labor Market Strength Moderating

Q2 Earnings in the Home Stretch

Two more tech heavyweights report
Besides jobs data, many of us were glued to our screens Thursday after the bell to see how two of the world’s biggest tech firms fared in the second quarter, as Apple and Amazon released their Q2 results. It was an unequivocally good quarter for Amazon, whose shares popped more than 8% on Friday as it beat expectations on both the top and bottom lines, sending analysts scrambling to update their forecasts; Reuters reported at least 26 analysts raising their price targets on the company by the end of the week, pushing the median implied upside on Amazon shares to 32%, based on Friday’s close. Like many analysts, we were keen to see how Amazon’s cloud unit AWS performed as businesses tighten their belts in a challenging macro environment, and though growth continues to slow, the division performed better than expected. Apple wasn’t so fortunate, modestly beating on earnings, but posting a third consecutive quarter of year-over-year contraction in sales—the longest such run for Apple in almost seven years—with guidance suggesting a fourth consecutive quarter of falling revenues was in the cards as iPhone sales slid. Apple’s shares closed down nearly 5% on Friday.


Broader beats mask declining earnings
Despite Apple’s gloomy guidance, the tech sector has put in a solid second quarter. More broadly, at least on the face of it, this earnings season has been a good one for US firms. As of last Friday, according to data from FactSet, 84% of S&P 500 firms had already reported Q2 results, with 79% of those companies beating Wall Street forecasts on EPS—well above the five-year average beat rate of 77%. Earnings have come in 7.2% above estimates, just a little less than the 8.4% five-year average earnings surprise. Unfortunately, those rather rosy stats versus expectations belie the fact that analysts’ projections have also gotten pretty gloomy over time, such that “beating” Wall Street forecasts won’t necessarily be enough to make investors happy. Along those lines, using FactSet’s calculation of actual earnings for the 84% of S&P 500 firms already reporting and estimates for the 16% releasing results in coming weeks, we’re currently on track for a -5.2% year-over-year decline in earnings since Q2 2022, which would be the biggest year-over-year decline since Q3 2020, when global COVID lockdowns were severely cutting into US firms’ results. If analyst forecasts are soft, it would certainly explain why companies reporting positive surprises in Q2 are actually falling in price in the days following earnings announcements: investors are already pricing in too much good news. That would, in turn, explain the S&P 500’s cyclically adjusted P/E today, hovering over 30x vs. its 17x long-term average.