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US rating downgrade has far-reaching consequences

Fri, 08/11/2023 - 12:05

The news last week of ratings agency Fitch's decision to strip the US of its AAA credit rating was nothing short of groundbreaking. For over a century, the United States has been a debtor of choice for many major financial institutions on account of its strong, stable, and very large economy. However, Fitch stated in a recent report that: "The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance".

US Treasury Secretary Janet Yellen, meanwhile, called the move "arbitrary", asserting that the decision was based on "outdated data". However we analyse the situation, it's undeniable that the US has shown uncharacteristic weakness in recent months. First, we had the collapse of several major banks. Then, there was the June bipartisan agreement to lift the debt limit to $31.4 trillion until January 2025, which almost saw the US default on its existing commitments.

Now, another rating agency, Moody's, has decided to downgrade 10 mid-sized US banks and has placed six banking giants, including Bank of New York Mellon (BK.N), U.S. Bancorp (USB.N), State Street (STT.N) and Truist Financial (TFC.N), on review for potential downgrades. The response from the markets was immediate, with all three major US indices experiencing sell-offs. The Dow Jones Industrial Average (DJIA) fell 0.45% to 35,314.49, the S&P 500 (SPX) lost 0.42% to reach 4,499.38, and the Nasdaq Composite (IXIC) dropped 0.79% to 13,884.32. While it might not seem like much on the surface, this could well be just the tip of the iceberg. A growing sense of uncertainty and worry is growing in the US market and, by extension, the world. Traders and investors are understandably concerned and keen to grasp what the future might hold for their capital. 

Equity release

Apart from the initial dip that is to be expected after such an unprecedented development, the longer-term outlook for US stocks is cloudy at best. Both the S&P 500 and Nasdaq 100 indices have been up and down all year and have only managed an average of a 6% gain since August 2022. This sideways movement speaks to a larger issue that has prevented equities from gaining any sort of real traction since the post-pandemic crash of late 2021. One of the biggest factors behind this uncertainty has been the above-target inflation that has plagued both the US and the wider world. As traders braced for the latest US inflation numbers on Thursday (10/08), further declines were expected. According to Reuters analysts, they tipped consumer prices to reveal a 3.3% year-on-year increase in July, up from 3% in June. This would be the first acceleration in inflation since June 2022 and could spell trouble ahead for already-wavering equities. 

Buried Treasury

Ironically enough, despite the downgrading of the US Treasury's creditworthiness, bond yields have actually been outperforming the expectations of many analysts. Indeed, it seems the worse the prospects of stocks, the better T-note yields look. In fact, data from BofA Global Research showed the one-month correlation between the S&P 500 and the 10-year T-note yield at their most negative since 2000, which means the two assets are once again moving sharply in opposite directions. At the current level of 4.003, the 10-year is actually up almost 10% MoM, which, at first glance, seems illogical given the US's credit rating woes. 

However, if we return to rising inflation, the picture becomes much clearer. Coupled with the Federal Reserve's firm stance on future rate cuts — having all but ruled out any reductions this year — the case for government bonds becomes stronger. And with the stock market looking stagnant, T-notes offer a relative safe haven for investor capital over the medium term. What's more, the 2- and 5-year Treasury bills offer even more attractive yields (4.80% and 4.13%, respectively), making them particularly solid buys for risk-off investors looking to ride out the turbulence.

Nowhere to turn

The prospect of holding the bulk of their capital in cash or bonds is an ignominious last resort for many die-hard bulls. In situations such as these, the risk-friendly would typically look to low-correlation regions like China to put their money to work. Unfortunately, though, even these markets have felt the impact of the recent turmoil. Beyond the contagion effect of the US credit downgrade, China's stock market has its own deeply entrenched problems. News that China's consumer prices had slipped into negative territory for the first time in 28 months in July sparked further sell-offs on the already reeling Chinese and Hong Kong equities markets. Mainland Chinese markets closed lower on Wednesday (09/08), with the Shanghai Composite down 0.49% to 3,244.49 at the close of play.

The Shenzhen Component, meanwhile, dropped 0.53% to end the day at 11,039.45, while Hong Kong's Hang Seng index was just about hovering above the flatline in its final hour of trade. This comes after a torrid year for the flagship Hang Seng, which is already down more than 10% YTD. On the bright side, these multi-year lows do suggest good buys for long-term investors, but it looks like they'll have to be extra patient for significant returns.

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