Markets tugged lower by a credit downgrade and interest rates; inflation in focus this week

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — August 07, 2023

Fitch's U.S. credit downgrade a gentle reminder of fiscal concerns

Helping to weigh on stock sentiment last week, at least to a small degree, was Fitch’s downgrade of the U.S. credit rating to AA+ from AAA. In May, the rating agency had placed the U.S. on a rating watch, partly due to the debt ceiling drama unfolding at the time. Fitch noted an, “expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA and AAA peers” as reasons for the downgrade. Recall Standard & Poor’s downgraded the U.S. debt rating one notch below AAA back in August 2011 amid a similar debt-ceiling skirmish in Congress at the time. However, Fitch’s move is unlikely to impact U.S. borrowing costs, and U.S. government debt and its currency remain one of the safest investments in the world. Notably, U.S. Treasuries are the benchmark asset for safety and liquidity. We believe nothing about Fitch’s downgrade or its rationale changes that point. That said, rating agencies are growing more concerned with the fractured political system in the U.S., increasing debt burdens, and the general unwillingness to tackle key items around the U.S. debt burden, such as Social Security and Medicare and Medicaid. Although Fitch's U.S. downgrade does little to alter the investment landscape in any material way, it’s nonetheless a gentle reminder that our current fiscal course and political structure may not be on the most productive path.

Credit downgrade contributes to backup in yields

However, the more pressing concern for the market last week was the backup in yields, partly precipitated by Fitch’s downgrade of the U.S. While U.S. Treasury performance was mixed across the curve, yields steepened. The 2-year and 10-year U.S. Treasury spread narrowed to around -50 basis points from -87 basis points last week, while the 10-year Treasury yield rose above 4.10% at one point during the week, which marked the highest level in ten months. By the week's close, the 10-year yield settled at 4.05%, up nearly ten basis points. Notably, the 2-year Treasury yield fell almost ten basis points last week. This implies the move higher in yields (generally centered around the long end of the curve) was in response to concerns about higher inflation and potentially higher rates for a longer period. As a result, stocks felt some pressure last week, not necessarily from Fitch’s move directly but from the indirect impact on rates, which bumped higher on the long end. Given stocks are long-duration assets, the move higher in long-term rates implies a lower return when future corporate profits are discounted back to current rates. Simply, a more technical explanation of a market dynamic that often sees lower stock prices when rates rise.

Apple, Inc. beats estimate

On the week, Apple Inc. beat both earnings per share and sales estimates for the previous quarter, driven by stronger services revenue. However, product results and the outlook for the current quarter were mixed. Also, Amazon reported double-digit revenue growth in the last quarter and posted its largest EPS beat since Q4’20, driven by stronger-than-expected profit across AWS. With those two key profit reports out of the way, investors can safely say Big Tech earnings avoided any major disappointments this earnings season, which net-net is a positive for the bulls. With 84% of Q2’23 S&P 500 profit reports completed, 79% of companies have surpassed earnings per share (EPS) estimates which is above the five-year average of 77%. Notably, Q2’23 S&P 500 EPS improved to down 5.2% year-over-year last week, from down 7.4% the previous week. Yet despite the improved earnings trends, S&P 500 companies remain on pace for their worst quarter of profits since Q2’20.

Sentiment shifts amid mixed signals

On the economic side, employment momentum in the U.S. is slowing but remains firm. July nonfarm payrolls grew by +187,000, missing the consensus estimate of 200,000 and putting in its lowest point since December 2020. June and May jobs were revised lower by 49,000, and the unemployment rate ticked down to 3.5% in July, only slightly above the 54-year low of 3.4%. Although average hourly earnings came in slightly hotter than expected, falling hours worked helped to offset labor inflation pressures. Bottom line: The employment backdrop is cooling but isn’t falling out of bed. And while market participants can debate whether the labor market is still too hot for the Federal Reserve’s liking, there is evidence that a soft landing remains an open possibility following three-plus years of extremes. Those who thought we would be in a recession by this point have been proven wrong. And those that continue to hold an overly bearish view of the U.S. economy are undoubtedly challenged by data such as last week’s employment report. Interestingly, if continued firmness in labor markets isn’t enough to drive that point home for investors, possibly the Atlanta Fed’s current +3.9% Q3’23 GDPNow forecast will help remind the bears the U.S. economy appears a long way from driving itself into a ditch. Indeed, there are risks to slowing growth that investors shouldn’t ignore, arguing for a generally balanced portfolio at this point. But we believe being too conservative and pessimistic about asset prices is also a risk that can damage portfolios longer-term.      

But before everyone becomes too giddy about a still strong economy, it’s important to remind investors that the S&P 500 and NASDAQ Composite are coming off five straight months of gains, which have pushed both indexes well above their moving day averages and stretched valuations based on this year’s earnings expectations. Given stocks' upward momentum during recent months, sentiment indicators have also become stretched as of late. In the latest Investors Intelligence Survey, the number of bulls rose to 57.1% from 55.6% the prior week. That’s the highest level of bulls since November 2021 and exceeds the 55% threshold typically associated with investor caution (i.e., a contrarian indicator that could signal weakening stock momentum ahead). And in the latest American Association of Individual Investors Survey, bullish sentiment has remained above its long-term average for nine straight weeks, with roughly 49% of survey respondents saying they are optimistic about future stock gains.

Seasonality trends in August and September are also not in the bulls' favor. That said, we believe a modest pullback, if one were to occur, shouldn’t derail the overall stock market longer-term. Not every week or every month can be a winner for stocks. After five straight months of stock gains, it might be a good idea for investors to keep that point in mind. As long as the overall macroeconomic narrative remains firm and activity continues to normalize and avoids a harder pullback, then investors shouldn’t be overly concerned with a stock market that treads water for a period or moves modestly lower from current levels. Given the number of investors caught offside this year by the rally and high cash levels, we wouldn’t be surprised to see stock pullbacks quickly bought as more investors look to get back into equities and shore up allocations.

With earnings reports beginning to slow this week, key inflation data on Thursday and Friday will likely test our statements above. On Thursday, the July headline Consumer Price Index is expected to come in at +3.3% year-over-year, hotter than June’s level of +3.0%, driven by higher gasoline prices. July core CPI is expected to hold firm at +4.8% year-over-year. On the wholesale side, the story is similar. The Producer Price Index is expected to have moved modestly higher in July on a year-over-year headline basis while remaining unchanged on a core basis. Bottom line: How investors react to this week’s key inflation reports, particularly against trends of slowing moderation or upticks in price pressures, may be an important signal for near-term stock direction. Most of the market sees the Federal Reserve holding the fed funds rate at its current level through the rest of this year. Depending on how this week’s inflation reports come in, that forecast may see some changing odds, creating more stock volatility in the near term. In addition to this week’s inflation reports, the July NFIB Small Business Index (Tuesday), weekly jobless claims (Thursday), and a preliminary look at August Michigan Sentiment (Friday) will be the economic highlights of the week.