Inflation + US Debt Ratings: Are We Out of the Woods?
MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.
Looking Ahead, this quarter we're thinking about the US debt ratings, inflation numbers, and investment implications as we move into 2024+.
MAIN TAKEAWAY:
Inflation has started to cool off, and real economic growth continues to be stronger than most forecasters were predicting to start the year. As economic growth has remained strong, those predicting a recession this year were likely incorrect. However, there are clouds on the horizon, and the biggest longer-term threat to economic growth is the U.S. government’s mounting debt relative to GDP.
top risks:
Consumer spending could come under pressure as pandemic-level savings are depleted and student loan payments restart. Since the Federal Reserve started tightening, auto loan and credit card delinquencies have increased, suggesting that some consumers may be overextended. Global inflation remains elevated, and with a trend toward deglobalization, slowdowns internationally have been more pronounced, especially in China. Oil prices have increased sharply over the past three months as OPEC+ countries have cut production.
sources of stability:
Core inflation is trending down, and although it remains above the Fed’s 2% target, the U.S. economy will likely avoid a recession in 2023. The labor market is still strong with historically low unemployment. The Fed is likely near the end of its tightening cycle, and although markets still see the possibility of one additional rate hike, the economy continues to deliver strong results. The services sector continues to be expansionary. Fiscal policy remains accommodative despite the strong economy and restrictive rates.
WHAT’S THE PRACTICAL IMPACT OF THE US DEBT DOWNGRADE?
Many criticized the downgrade of the U.S. government's debt as unnecessary.
On Aug. 1, 2023, Fitch downgraded the U.S.’s long-term foreign-currency issuer default rating to 'AA+' from 'AAA', its highest possible rating. The credit rating agency cited deteriorating fiscal conditions, weaker governance, as well as an underfunding of Social Security, Medicare and Medicaid (along with an aging population) as justification. This was the second time in history that a rating agency has lowered the U.S. debt rating, following Standard & Poor's downgrade to 'AA+' from 'AAA' in 2011.
Market reactions to the news were muted. Both stock and bond markets were slightly down, but bonds recovered the following week. And practically, the downgrade does not have much of a near-term impact.
This is a signal, however, that the U.S. is not invulnerable to deteriorating credit conditions and downgrades. Over the longer term, if foreign investors lose confidence in the U.S. government’s ability, or willingness, to repay its debts, they may choose to sell a portion of their Treasury debt, putting upward pressure on interest rates. And with 31% of federal debt maturing over the next 12 months, higher rates could continue to exacerbate the U.S. government's deficit problem.
INVESTMENT PLANNING IMPLICATIONS
Where do markets go from here?
Tighter consumer budgets and tight labor markets could lead to weaker corporate profits. With the resumption of student loan repayments, the dwindling pandemic savings and tighter credit conditions, consumers may be forced to cut back on discretionary spending. Although many businesses have pre-emptively tightened budgets, this could trickle to less revenue and profits for some companies.
Expect increases in company defaults and losses, especially in sectors more susceptible to higher interest rates. Companies will have more trouble accessing new capital or rolling over existing loans given the tighter credit conditions. The equity and debt securities of higher-quality companies are likely to perform better in such an environment.
Valuations suggest a breadth of expected returns going forward. Although growth stocks typically trade at higher multiples than value stocks, the spread between value and growth stocks is near all-time highs. Although this can’t reliably be used to time the markets, this suggests value stocks have a higher expected return going forward.
What are the investment planning implications?
Plan for a market downturn. Two of the worst four declines in the S&P 500 over the last 30 years have happened in the last 36 months. We know another decline is going to happen, we just don’t know when. Work with your advisor to write out a plan for how you want to respond to the next downturn.
Be mindful of interest rate risk. Although long-term bonds are alluring to lock in these high interest rates, keeping your bond portfolio on the short to intermediate side helps to mitigate the overall risk in the portfolio. Longer-term bonds have larger swings in value as interest rates change.
Consider alternative sources of risk and return. Bonds serve as the bedrock of the portfolio, and stocks serve as an engine of growth. Given the headwinds to economic growth and corporate profits, investors could consider a small allocation to alternative sources of risk and return. Areas such as real estate funds, if implemented correctly, could be additive to the overall portfolio.
