Executive Summary
As the most aggressive interest rate-hiking cycle in recent history seemingly nears its final stages, economic activity is better than expected, bond markets are providing the opportunity to construct portfolios that generate higher yields, and equity markets are near all-time highs.
What Piqued Our Interest
On August 1, Fitch Ratings downgraded the U.S. long-term default rating from AAA to AA+. The downgrade, per Fitch, was due to “a steady deterioration in standards of governance” and was “manifested in repeated debt limit standoffs and last-minute resolutions.” U.S. debt still carries a credit rating of “very strong capacity” but no longer holds the top rank. Implications may look like when S&P also downgraded U.S. debt more than a decade ago in 2011. Interestingly, this latest downgrade comes at a time when expectations of a looming recession have decreased considerably.
Since the pandemic, inflation has been at the forefront of both market and economic concerns. This drove central banks to act, with 95% of the world’s central banks raising rates since 2021. In the U.S., the Fed Funds Rate increased from zero to 5.25% in a span of 16 months. The magnitude and pace of these interest rate increases—something not seen in decades—heightened concerns that a major credit event would occur and could lead to a recession, or “hard landing.” However, with the latest Consumer Price Index (CPI) report showing that the annualized rate of inflation has declined to 3%, alongside the most recent report of U.S. Gross Domestic Product (GDP) growth at 2.4%, recession fears are dwindling, and a more palatable “soft landing” narrative has continued to gain steam.
Past economic cycles have been much more sensitive to rising interest rates, leaving many perplexed by the current resilience in both the economy and investment markets. However, several factors today are helping to buck past trends. Those factors include, but are not limited to, household and corporate balance sheet strength, the magnitude of liquidity created during the pandemic (which mostly remains in the global financial system), fiscal policies that have boosted infrastructure and manufacturing sectors, and digital transformation in the form of artificial intelligence (AI).
As frequently discussed, balance sheet strength is a key contributor to economic resilience. Many households and corporations have spent the past decade reducing leverage or restructuring debt at lower interest rates. For example, approximately 42% of owner-occupied houses had no mortgages as of 2021. Of the remaining houses that did have mortgages, 75% of these mortgages carry 30-year fixed rates below 4%. For corporations, interest expense as a percentage of cash flows is the lowest in decades, and for the first time, the actual level of interest expense has fallen while the Fed hiked rates. However, as witnessed by the recent credit rating downgrade, it is the U.S. government’s balance sheet that will likely need to be shored up going forward.
At the onset of the pandemic, central banks eased policy, and governments provided stimulus that amounted to the creation of over $11 trillion in global liquidity. To date, central banks have only reversed about 35% of the emergency stimulus money. The post-pandemic world also has many businesses reevaluating their supply chains, and fiscal policies like the CHIPS Act, the Infrastructure Bill, and the Inflation Reduction Act have all continued to provide tailwinds to economic growth.
Lastly, the digital disruption of AI and the growth of this industry has also contributed to the “soft landing” scenario. Although aspects of AI—such as machine learning and natural language processing—have been discussed by tech companies since 2020, the world was introduced to the possibilities of AI when OpenAI’s ChatGPT was launched and reached 100 million users in just three months.
However, there are reasons to believe that the impact of higher rates will have a lagging and prolonged effect, as corporations and households will eventually need to access capital. Valuations—on everything from stocks to real estate—have yet to fully adjust to the lower net present values of cash flows that get discounted back at higher interest rates. On top of that, student loan payments are set to resume in October, and according to Apollo Global Management, there are a total of 45 million people with student loans, with an average monthly payment of around $200. Thus, resuming student loan payments will subtract roughly $9 billion from consumer spending every month, or roughly $100 billion per year.
Market Recap
Equity markets climbed higher in July, with the S&P 500 Index up 3.2% for the month, bringing the year-to-date return to over 20%. There are divergences within equities, as the blue chip Dow Jones Industrial Average (DJIA) is only up 8.6% for the year, while the Technology-heavy Nasdaq 100 is up an astonishing 44.7%. Much of the returns in the Nasdaq and the S&P 500 Index have been driven by the Mega Cap Technology names, and the Nasdaq 100 did a “special rebalance” in July to address the index’s high level of concentration among those names. Small Cap stocks continued their outperformance from last month, with the Russell 2000 Index up 6.1% in July. International stocks have also seen double-digit returns this year, beating out the returns of U.S. Large Cap Value and the DJIA but underperforming the S&P 500.
Within fixed income, rates moved higher across the curve, as the Fed raised interest rates by another 0.25% at their meeting in July after pausing in June. Additionally, Treasury yields moved higher towards the end of the month when the Bank of Japan announced that it would take a step towards normalizing monetary policy and be more flexible with their yield curve control. Japan is the largest holder of U.S. Treasuries, so if Japanese Government bonds carry a higher yield, this could make owning U.S. Treasuries less attractive—especially after considering the impact of foreign currency. With that, the 10-year Treasury yield is back towards the highs of the past year, and the Bloomberg Barclays U.S. Aggregate Bond Index fell slightly, down -0.07%. High-Yield Corporates gained 1.4% in the month, as corporate sector resilience contributed to narrower spreads over Treasuries. Lastly, Commodities saw a strong rebound from the lows in May and were up 6.3% in July.
Closing Thoughts
Cooling inflation, strength in the labor market, and equity markets near all-time highs have provided optimism that a recession may be avoided, but we are mindful that structural differences in both the economy and markets may have both softened and delayed a potential recession. In the near-term we acknowledge that markets have priced in much of this optimism while also expecting rates to come back down in the next 12 to 18 months. If the impact of monetary policy has been delayed, the ramifications of higher interest rates may still need to work through the financial system and economy.
