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Our Top Market Takeaways for August 4, 2023

Market update: Summertime sadness

August started with a stumble. After a strong run, stocks had a tougher week as bond yields shot higher. Now above 4.15%, 10-year Treasury yields are at levels unseen since November. Meanwhile, yields for shorter-dated bonds have barely budged (bets are still on that last week’s Fed hike was the last).

So, then, what’s behind the moves?

Fitch’s U.S. debt downgrade. Earlier this week, Fitch (one of three major credit rating agencies) downgraded the U.S. government’s credit rating to AA+ from AAA (the highest possible rating). But that’s just one reason, and probably not the most important one…

A better growth backdrop. The data for a still-strong, albeit slowly cooling economy, continue to roll in. More on that later.

A ramp-up in Treasury issuance. The U.S. Treasury (the pocketbook for the government) said it plans to boost bond sales a bit more than expected. All else equal, more supply can put downward pressure on prices and upward pressure on yields.

Jitters from the Bank of Japan’s (BoJ) policy tweak last week. Policymakers eased their grip on their yield curve control (YCC) policy, calling its current 0.5% ceiling a “reference” instead of a hard limit. Given the BoJ has kept policy easy while the rest of the world hiked, some are taking it as a sign that one of the last “anchors” for global interest rates is coming loose.

To us, the charge higher in yields doesn’t necessarily seem like a bad thing, especially as it, in part, reflects a world with better growth and easing inflation. Given the S&P 500’s approximately 18% year-to-date ascent, frothy valuations in some pockets of the market and low liquidity as traders hit the beach, we wouldn’t be surprised by choppy markets or even a late-summer swoon. But with the near-term macro and micro backdrop holding up, we still have an outlook for stronger markets over the next year.

Spotlight: Let’s talk about the U.S. debt downgrade

In its downgrade move, Fitch called out the U.S. government’s ongoing reliance on debt to finance its spending (with deficits expected at about 6% of GDP over the next three years). Over time, that adds to the already-ballooning total U.S. debt stock: federal debt held by the public is now around 97% of GDP. That’s a lot, and managing it has been made all the more complicated by division in Washington.

The chart describes the size of U.S. debt since 1920.

The first and only other time the U.S. faced a downgrade was during the 2011 debt ceiling episode, when Standard & Poor’s similarly demoted the U.S. to AA+ from a AAA rating (a move that was never reversed). That means Moody’s is the only major rating agency that still puts the U.S. in the highest category.

 So should you be worried? Here’s how we think about it: 

What we’re not worried about:

Default. The U.S. government remains in a strong position to keep making its interest payments. The issues that prompted the move are known problems, rather than a reflection of any new news. Fitch also said back in May (when all the debt ceiling drama was still in motion) that they were weighing downgrading the U.S. government’s credit rating. If anything, it was more just the timing of the announcement that was a surprise.

Today’s economy. The labor market is still strong (the economy added another healthy amount of jobs in July, albeit at a slightly cooler pace). Consumers are still spending (for what it's worth, Taylor Swift just added more dates to her North American tour). And that broad economic strength is showing up in a number of bellwether companies’ earnings (take manufacturing giant Caterpillar, for example, which soared to record highs on a blockbuster report earlier in the week).

What we’re worried about now:

A potential government shutdown. While the debt ceiling has been suspended until January 2025, the budget for the new fiscal year has to be approved by September 30 (in less than two months). With the government’s debt burden in such acute focus, spending disputes across and within party lines seem likely. That means that the possibility of a government shutdown can’t be ignored. We’ve dealt with the risk and reality of shutdowns many times before, but such episodes also tend to lead to some – albeit short-lived – market and economic angst.

What we’re worried about later:

The long-term problems of a lot of debt. Michael Cembalest, our Chairman of Market & Investment Strategy, has called out how, over time, growing debt can crowd out other types of productive spending.1

The larger the pile of debt, the more the government has to pay in interest expense. That makes decisions harder over how to allocate discretionary spending (like healthcare, transportation infrastructure, science, education, and the like). At some point, government spending on entitlements, other mandatory outlays, and debt interest will outstrip its revenues, and this will probably lead to a painful wake up call for policymakers – but it may just take another decade or so to get there:

The top chart shows Entitlement spending and Non-defense discretionary spending from December 1965 to December 2033

The knock-on effects, like on the dollar. Worries about deficits and debt tend to prompt questions over whether the dollar can hang onto its crown as the reserve currency of the world. Yet, today, the dollar’s importance is unparalleled in currency trading markets, international trade, international banking and foreign exchange reserves across economies. As an example, the U.S. dollar makes up one side of almost 90% of FX transactions, and it’s used for around half of all trade invoicing. So while history suggests its reign may not be as strong as it is today forever, its position on the throne still looks secure, at least for the next few decades.

In sum:

Fitch’s downgrade calls out the long-term challenges around the large and growing stock of U.S. debt, and at some point those must be reckoned with – but it doesn’t bring new risks or information.

Investment considerations: Maintain a long-run mindset

We understand that you might be nervous. While this week’s news flow doesn’t change our constructive outlook for the next year, it can help to remember your long-term investment plan. Uncertainty and volatility can make navigating the market difficult. But over time, diversified portfolios have been able to smooth the ride, especially through the bad stuff.

This chart shows rolling annualized total returns, from 1950 until 2022, on a 1-year, 5-year rolling, 10-year rolling, and 20-year rolling basis, for stocks, bonds, and 50/50 portfolio.

Your J.P. Morgan team is here to help.

All market data from FactSet and Bloomberg Finance L.P., 8/4/23.


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