- August is historically a weak month for the stock market, and this year has been no exception.
- Fitch, a major credit rating agency, downgraded the U.S. debt rating from AAA to AA+ due to concerns about rising debts and deficits over the past two decades. The growing deficit, which doubled to $1.6 trillion in 10 months, raises questions about fiscal responsibility. Interest costs on the debt are also increasing, consuming a significant portion of tax revenue.
- Treasury yields have surged, with the 10-year yield reaching levels not seen since 2007. This is driven by concerns over ballooning debt, weaker treasury auctions, reduced demand for bonds as the Fed shrinks its balance sheet, and expectations of a soft landing scenario.
- Fed Chairman Jerome Powell's speech in Jackson Hole left investors with uncertainty about the direction of interest rates. While Powell acknowledged that interest rates are in restrictive territory, he didn't provide a clear plan to return inflation to 2%. The market assumes no rate changes at the next meeting, adding to the uncertainty.
- Pullbacks in the stock market are inevitable, especially during weaker months like August, September, and October. While the economic picture remains cloudy, there are just as many positives as there are negatives, but most importantly, the longer-term bull market remains intact.
August, as tradition holds, is known for being one of the seasonally weaker months in the stock market calendar. The events of this August only served to reaffirm this reputation.
As of August 24th, the S&P 500 Index has retreated by -4.63% during the month. The Russell 2000 Index (RUT), which represents U.S. small-cap stocks, fell by -7.83%, and international developed stocks, as represented by the MSCI EAFE Index, dropped by -5.71%. Additionally, the Bloomberg US Aggregate Bond Index, which tracks U.S. investment-grade bonds, saw a slump of -1.59%.
Source: YCharts. Nova R Wealth. 8/1/2023 – 8/24/2023.
The month began with bad news on the very first day as Fitch downgraded the US credit rating to AA+. Subsequently, market sentiment soured due to rising Treasury yields. And, to cap it all off, Fed Chairman Jerome Powell's speech in Jackson Hole, Wyoming, at month's end, left investors with more questions than answers regarding the direction of interest rates.
Credit Agency Downgrades
Fitch, a well-known ratings agency, downgraded the U.S. debt rating from AAA to AA+, joining Standard & Poors (which downgraded the U.S. to AA+ in 2011). Fitch cited an “erosion of governance” over the past two decades and rising debts and deficits as the main culprits for the downgrade.
While the timing of the downgrade seemed abrupt, the reasoning is certainly hard to argue with. “How much debt is too much” is an age old debate, but given this year’s surge in the deficit, it’s hard not to ask the question once more. The deficit this year—which more than doubled to $1.6 trillion in the 10 months through July—looks like what happens when the government goes into recession-fighting mode. Except right now the economy is growing faster than expected and does not seem to be in dire straits.
Projections for the U.S. budget balance as a % of GDP, like the one shown below from the Congressional Budget Office (CBO), only seem to show the problem getting worse.
Furthermore, as interest rates have risen precipitously over the last three years, so too have interest costs to finance the country’s debt. According to Brian Rehling, head of global fixed income strategy at Wells Fargo, net interest on debt as a share of Federal Revenue, gobbles up about 14% of tax revenue. This is projected to rise to over 20% past 2030, according to the CBO.
Having a greater and greater share of revenue consumed simply to pay debt servicing costs to bondholders does not result in a productive use of capital for the country.
In October 2022, we observed the 10-year Treasury yield reaching its peak. Intriguingly, this pinnacle aligned with what appeared to be the dawn of a prospective equity bull market. However, in the recent month, we've witnessed a sharp spike in yields, with the 10-year reaching altitudes not witnessed since 2007.
What are the main catalysts for the surging yields?
As mentioned above, ballooning debt and deficits are spooking investors, resulting in weaker treasury auctions and higher yields. On top of this, the Fed is also reducing the size of its balance sheet, providing less demand for bonds.
Investors are also pricing in a bit of a soft landing scenario. U.S. retail sales jumped 0.7% month-over-month in July, the fourth-consecutive month of increasing consumer spending on goods.1 Moreover, the Atlanta Fed GDPNow Model is predicting Q3 GDP growth of 5.8%. A growth level this elevated raises doubts that the Fed is done raising interest rates.
On Friday, August 25th, Federal Reserve Chair Jerome Powell delivered a speech about the economy and monetary policy. Cameron Crise at Bloomberg summed it up by writing, “In the end, Jerome Powell’s Jackson Hole speech might have been written by Shakespeare, because it seems as if all the anticipation was much ado about nothing.”
Although Powell acknowledged that the federal funds rate is in restrictive territory, he was unable to provide a direct response on how restrictive the Fed should become in order to return inflation to 2%. There was no announcement if rates will be unchanged at the September meeting, but the market appears to assume there will be no change at the next meeting, according to Bloomberg.
Similar to a bruise or a strained muscle, market corrections constitute a commonplace and inevitable facet of being an investor. And while pullbacks are painful in the moment, they usually heal pretty quickly and are soon consigned to oblivion. The key is rest.
As we transition from August to September and October, these months hold their own unique positions in Wall Street's history. In this season, it's crucial to assess the challenges and uncertainties on the horizon. These include a potentially weakened Chinese economy, rising interest rates, and an inverted yield curve. Nevertheless, it's essential to balance these concerns with some positive factors. Corporate earnings have shown resilience, and the most challenging phase of the interest rate hike cycle might be behind us. While the economic picture remains cloudy, there are just as many positives as there are negatives, but most importantly, the longer-term bull market remains intact.
(1) U.S. Census Bureau.