Dear Friends,
As we’re enjoying the final days of summer, the shadow of a recession appears to be gradually lifting for the US economy. Just last week, the Fed implemented yet another interest rate hike, which could be the conclusion of this rate hiking cycle. Notwithstanding, a new cloud of uncertainty hovers as Fitch downgraded the US credit rating this week from AAA to AA+. More on this economic twist below.
Economy, Geopolitics, and Commodities
1. Fitch Downgrades U.S. Credit Rating
Fitch, a London-based firm, is one of the 3 major credit rating agencies, which downgraded the U.S. government’s credit rating weeks after President Biden and congressional Republicans came to the brink of a historic default, warning about the growing debt burden and political dysfunction in Washington. The downgrade, the first by a major rating firm in more than a decade, is evidence that increasingly frequent political skirmishes over the U.S. government’s finances are clouding the outlook for the $25 trillion global market for Treasurys. Fitch’s rating in the U.S. now stands at “AA+”, or one notch below the top “AAA” grade.
America’s reputation for reliably making good on its IOUs has cast Treasury bonds in an indispensable role in global markets: a safe-haven security offering nearly risk-free returns. Treasurys serve as a critical benchmark for returns on stocks and other bonds because investors generally demand greater yields on any other securities that they buy that may pose more risk. Fitch forecasted the US debt-to-GDP ratio, which is the metric comparing a country’s public debt to its gross domestic product (GDP). By comparing what a country owes with what it produces, the debt-to-GDP ratio reliably indicates that particular country’s ability to pay back its debts. 118.6% was the U.S. debt-to-GDP for Q1 2023—almost double early 2008 levels but down from the all-time high of 134.8% seen in Q2 2020. The debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3% of GDP and ‘AA’ median of 44.7% of GDP. Fitch’s longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks.
Few investors believe that Fitch’s downgrade will immediately challenge the role of US Treasuries. Still, it is the first time a rating firm lowered its headline assessment of the U.S. government’s propensity to pay its bills on time since Standard & Poor’s in 2011 lowered its rating one notch below the top grade. That decision followed another tense debt-ceiling standoff in Congress. Moody’s, the other member of the three big U.S. ratings firms, continues to give the U.S. its strongest assessment.
2. A Goldilocks Job Market Is in Sight
America’s job market is cooling. It isn’t cool enough for the Federal Reserve just yet, but it is getting there. The Labor Department on Friday reported that the economy added a seasonally adjusted 187,000 jobs in July, a month earlier fewer than the 200,000 that economists polled by The Wall Street Journal expected. It also revised the previous two months’ job gains lower. Even so, the unemployment rate, which is based on a separate survey from the job figures, slipped to 3.5% in July from 3.6% in June. That underscores a simple fact: The pace of job gains is probably still far too fast to prevent the unemployment rate from heading lower in the months ahead. And if the unemployment rate falls, it will reinvigorate worries over wage inflation, which could lead Federal Reserve policymakers to raise rates even more.
Immigration into the U.S. has bounced back. This is partly because President Biden’s immigration policy is less restrictive than former President Donald Trump’s, but it is also because the pandemic provoked a crash in immigration. Since then, there has been a rebound. Census Bureau figures show that, in the year ended July 1, 2022, the U.S. population grew by about 1.3 million people from the prior period after adding only about 520,000 in the year ended July 1, 2021. Most of that came because of a pickup in net immigration, which added about one million people to the population, a Brookings Institution analysis shows, after adding only about 376,000 the prior year.
Indeed, the Labor Department in February adjusted its population estimates higher. That also resulted in an addition of 871,000 people to its labor force estimate—that is, the number of people who are employed or actively looking for a job. It upped its population estimate when it made its population adjustments the prior year, and, if immigration continues at its recent pace, it might be releasing upward adjustments again next February. A larger share of the working-age population than the Labor Department projected has been working. That, too, is a plus. It projected a labor-force participation rate of 61.5% for this year, but Friday’s report showed the participation rate stood at 62.6% last month. The participation rate is still below the 63.3% it held before the pandemic and well short of the peak of 67.3% it hit in early 2000. One issue here is that, in an aging country, retirees are making up an ever-increasing share of the population. But lately counteracting that force has been a pickup in the so-called prime-age participation rate—that is, labor-force participation among people aged 25 to 54. Last month it was 83.4%, which was better than it was just before the pandemic. The upshot is that while job growth might still need to slow more to convince the Fed to ease up on rate increases, it might not need to slow that much more. The economy can probably handle more jobs than some people feared.
3. Federal Reserve Raises Interest Rates to 22-Year High
The Federal Reserve resumed increasing interest rates on July 26th with a quarter-percentage-point increase that brought them to a 22-year high. Fed Chair Jerome Powell said it was too soon to tell whether the hike would conclude a series of increases aimed at cooling the economy and bringing down inflation. The central bank would decide whether to keep lifting rates based on how the economy fares in the months ahead, “with a particular focus on making progress on inflation,” he said at a news conference.
The unanimous decision to raise the benchmark federal funds rate to a range between 5.25% and 5.5% follows a brief pause in increases last month. It marks the 11th rate rise since March 2022, when they lifted rates from near zero. Markets were mixed after the Fed decision. The S&P 500 finished about flat on July 26th, while the tech-heavy Nasdaq moved slightly lower. The benchmark 10-year Treasury yield fell to 3.850% after climbing to 3.911% the day before.
At their previous meeting in June, officials held rates steady but penciled in two more increases this year. Fed officials are scheduled to meet three more times this year, with the next meeting in September. Powell’s mission going into the meeting was likely to keep market expectations of another rate rise later this year “priced as a coin flip,” said Daleep Singh, a former executive at the New York Fed who is now chief global economist at PGIM Fixed Income. “Pricing the next set of decisions as a coin flip maximizes flexibility for the Fed to react to incoming data.” Fed officials have been concerned that underlying price pressures may prove more persistent as a solid labor market allows workers to bargain for higher pay, making it harder to get inflation down further. Core consumer prices, which exclude volatile food and energy categories, in June, posted the smallest monthly gain in more than two years, according to the Labor Department’s consumer-price index. But core prices rose 4.8% in June from a year earlier, a still-elevated level. Fed officials are focused on core inflation because they see it as a better predictor of future inflation.
4. U.S. Economic Growth Accelerates
Faster economic growth this spring raises the prospect of a longer post-pandemic expansion despite the Federal Reserve pushing interest rates to a two-decade high. The gross domestic product grew at a seasonally- and inflation-adjusted 2.4% annual rate in the second quarter, the Commerce Department said Thursday. That was faster than economists expected and above the 2% growth in the first three months of the year. Consumer spending cooled but rose enough to drive overall growth alongside much stronger business investment in the second quarter. Those factors combined to buck economists’ earlier expectations that a downturn would start in the middle of this year due to higher interest rates.
As inflation falls from historic highs and the labor market remains strong, solid growth adds to the prospect of a soft landing—in which inflation returns close to the Federal Reserve’s 2% target without a recession. Consumer spending grew at an annual rate of 1.6% in the second quarter, down from 4.2% growth in the first quarter. Household outlays account for the bulk of economic activity and were responsible for nearly half of the total rise in GDP. The slowdown largely reflected cooling purchases of big-ticket items after Americans snapped up vehicles at the start of the year as they flowed back onto dealership lots. Business investment grew at an annual rate of 7.7% in the second quarter, up sharply from 0.6% in the first quarter. Net trade slightly subtracted from second-quarter growth, reflecting a sluggish global economy. Residential investment declined for the ninth consecutive quarter. Recent declines in residential investment reflect housing-market strains amid higher mortgage rates.
Many economists still expect economic growth to ease later this year and into 2024, but they are dialing back recession fears. U.S. consumer confidence continued to improve in July, with many Americans expressing more optimism about the future, the Conference Board said this week. Consumers worried less about a recession. Small businesses are also feeling better about the economy. In July, 37% of small businesses said they believe the economy will worsen in the next 12 months, the best recording since February 2022, according to Vistage Worldwide, a business-coaching and peer-advisory firm. Economic growth in the U.S. and globally this year is likely to be stronger than previously estimated, the International Monetary Fund said last Tuesday. The improved outlook reflects labor-market strength, strong spending on services such as tourism, and diminished financial stability risks.
5. While Everyone Else Fights Inflation, China Deflation Fears Deepen
Signs of deflation are becoming more prevalent across China, heaping extra pressure on Beijing to reignite growth or risk falling into an economic trap it could find hard to escape. While the rest of the world tussles with inflation, China is at risk of experiencing a prolonged spell of falling prices that—if it takes root—could eat into corporate profits, sap consumer spending, and push more people out of work. Its effects would ripple across the globe, easing prices for some products that countries like the U.S. buy from China, but would also deprive the world of important Chinese demand for raw materials and consumer goods, while also creating other problems. Prices charged by Chinese factories that make products ranging from steel to cement to chemicals have been falling for months. Consumer prices, meanwhile, have gone flat, with prices for certain goods—including sugar, eggs, clothes, and household appliances—now falling on a month-over-month basis amid weak demand. Most economists think China will probably avoid a deep and lasting period of deflation. Its economy is growing, albeit sluggishly, and the government has unveiled a variety of small stimulus measures that could help more. Earlier in July, Liu Guoqiang, a Chinese central bank official, dismissed concerns that China is slipping toward deflation.
But some economists see alarming parallels between China’s current predicament and the experience of Japan, which struggled for years with deflation and stagnant growth. In the 1990s, a collapse in stock markets and real-estate values in Japan pushed companies and households to drastically cut back spending to service burdensome debts—a so-called balance-sheet recession that some see taking shape in China today. If China were to tip into protracted deflation, it has another big problem: Traditional methods of fighting it are either unpopular in Beijing or lack potency due to the country’s heavy debt load and other issues. Beijing is wary of large deficit-financed spending programs that could juice growth and push prices higher, while big debts mean consumers and businesses are reluctant to borrow and spend.
“The big concern is whether the policy tools that they have will have much traction in terms of trying to avert deflation, or deal with deflationary pressures once they arrive,” said Eswar Prasad, a professor of trade policy and economics at Cornell University and a former head of the International Monetary Fund’s China division. For the global economy, extended deflation in China might help cool inflation elsewhere, including the U.S., since its factories make up such a large share of the world’s goods. However, a flood of cut-price Chinese exports on global markets could squeeze out rival exporters in some countries, hurting jobs and investment in those economies. Chinese export prices for steel and chemicals fell by about a third over the 12 months through June. A deflationary spell in China would also likely mean weaker Chinese demand for food, energy and raw materials, which big chunks of the world rely on for export earnings.
6. European Central Bank Raises Rates
The European Central Bank raised its key interest rate by a quarter percentage point but signaled it might soon pause its yearlong campaign of rate increases, sending the euro tumbling. The ECB’s rate increase, its ninth in a row, took the bank’s deposit rate to a 22-year high of 3.75% from below zero a year ago. It echoed a quarter-point raise by the Federal Reserve a day earlier, though eurozone rates remain clearly below the Fed’s benchmark rate of 5.25% to 5.5%. The ECB’s signaling underlines the dilemma it faces compared with the Fed. Inflation is higher in the eurozone than in the U.S., and growth is much weaker, partly reflecting the shock of Russia’s war in neighboring Ukraine. The ECB needs to balance the risk that inflation stays too high for too long against the looming threat of recession, which has stalked the bloc for months.
The euro tumbled more than a cent against the dollar, to just below $1.10, and the yields on eurozone government debt fell, as investors concluded that the ECB would be cautious about further rate increases. The euro’s slide was exacerbated by data showing the U.S. economy grew faster than expected last quarter, which lifted the U.S. dollar against foreign currencies. ECB President Christine Lagarde acknowledged at a news conference that the outlook for the eurozone economy had deteriorated, particularly in the manufacturing sector. “We have an open mind as to what decisions will be in September and subsequent meetings…We might hike, and we might hold. And what is decided in September is not definitive, it may vary from one meeting to another,” Lagarde said. Future rate decisions would be based on incoming economic data, she said. That ambiguity reflects the high uncertainty facing Europe’s central bankers as the growth outlook darkens, inflation declines at different speeds in different places, and past rate increases hit household and business spending with a lag.
7. Manufacturing Contraction and Slower Services Growth in June
The JPMorgan Global Purchase Manager Index Composite output index posted 52.7 in June, down from 54.4 in May. This marked the first slowdown in the expansion of the global economy since growth commenced in February. The current reading is broadly consistent with solid annualized quarterly global GDP growth of 3%. The service sector remained the primary driver of the global economic expansion in June. That said, the pace of global services growth slipped to a four-month low amid signs of weaker consumer demand growth. Slower new business inflows for service providers underpinned the latest change, though demand was sufficiently strong to drive prices charged for services higher at a historically elevated rate.
The state of weakening demand conditions is far more severe among goods producers, however, as new order inflows into factories declined globally for a twelfth consecutive month in June and at the sharpest rate since January. A dearth of demand, coupled with the exhaustion of backlogged orders into the mid-year, led to global goods producers paring back production for the first time since January. This weak demand led to increasing numbers of producers offering discounts, driving factory gate prices lower for a second straight month.
Financial Markets
1. Stock Market Today: Indexes Finish Week Lower After Jobs Report
Stocks closed lower after Friday’s jobs report, with all three major U.S. indexes logging losses for the week. Indexes had climbed earlier in the morning, then wavered before turning negative. The yield on the 10-year Treasury edged lower in afternoon trading but rose for the week. The selloff in stocks in bonds came after Fitch’s downgrade of the U.S. credit rating earlier this week. On Friday, the monthly jobs report offered a mixed message on the state of the economy. U.S. employers slowed their hiring this summer, adding to signs that the economy is cooling. But wages continued to rise at a brisk pace.
Stock indexes ended in the red. The S&P 500, tech-heavy Nasdaq, and Dow Industrial all notched losses for the week. The yield on the 10-year Treasury fell. That followed a three-day rally. Amazon shares popped. The tech giant’s stock rose around 8% after it reported stronger-than-expected earnings late Thursday. Shares of electric-vehicle maker Nikola dropped Friday after the company said its chief executive would step down, to be replaced by its chairman. Nikola stock finished Friday off 26%. The company said Michael Lohscheller would be replaced by Steve Girsky, making Girsky its fourth CEO in about as many years. Nikola stock was up nearly 50% this year through Thursday’s close at $3.39, though well off its all-time high of around $80.Wheat prices rose after reports that Ukrainian sea drones attacked a Russian Black Sea port that is a major hub for oil and grain exports. Brent crude prices also edged higher. Utilities are this week’s big losers. The S&P 500 sector is down more than 4%.
2. Intel Returns to Profit as PC Rebound Lifts Chip Demand
Intel shares soared on July 27th as a resurgent personal computer market helped it bounce back from two quarters of record losses and it forecast new demand from the artificial intelligence boom. The $1.5 billion profit defied analysts’ expectations of another loss. It came after the $2.76 billion shortfall that Intel reported the previous quarter, the worst ever recorded for the storied chip maker. Chief Executive Pat Gelsinger said the company was on track with an ambitious turnaround plan articulated when he took the helm more than two years ago. He said demand for AI was poised to boost PC and data center divisions that have languished in recent quarters.
Intel’s revenue rose in the second quarter compared with the previous one, reaching $12.9 billion and exceeding Wall Street forecasts. Revenue was 15% lower than during the same quarter a year earlier. Intel shares rose 8% in after-hours trading following its results announcement. The company forecasts $12.9 billion to $13.9 billion of revenue in its current quarter, ahead of Wall Street estimates. Intel has been stung by a sharp fall in sales of PCs that drive a large share of its revenue. Sales boomed during the depths of the pandemic when people rushed to buy electronics to work and learn from home. That reversed last year as people reverted to old routines, leading to a glut of chips on manufacturers’ shelves.
The PC market has been showing signs of recovering in recent months as manufacturers run through chip inventories and make new orders. PC shipments declined 13.4% in the second quarter, according to International Data Corp., a more modest fall than the 29% rout in the first quarter. Gelsinger said in an interview that the company believed it gained market share in PC chips during the quarter and that the inventory situation had improved. Sales in Intel’s PC-chip division fell by 12% in the second quarter, the company said. But the $6.8 billion in sales topped the $5.8 billion for that division in the first quarter. Gelsinger suggested the future could be brighter for the division as interest in AI drives sales of PCs starting next year, with tools such as real-time language translation and productivity software add-ons enabled by a new generation of PC chips tuned for AI.
3. HSBC Net Profit More Than Doubles
HSBC’s net profit more than doubled to $18.1 billion in the six months ended June, a sharp spike compared to the $9 billion in the same period a year before. The bank’s profit before tax rose 147% year-on-year to $21.7 billion, up from $8.78 billion in the first half of 2022. This figure included a $2.1 billion reversal of an impairment relating to the planned sale of its retail banking operations in France, as well as a provisional gain of $1.5 billion on the acquisition of Silicon Valley Bank UK. In light of the strong results, HSBC’s board approved a second interim dividend of $0.10 per share and announced a further share buyback of up to $2 billion, which “we expect to commence shortly and complete within three months.”
For years the shares of Europe’s largest bank by market value underperformed, weighed down by low-interest rates and investor doubts about its long-term business model. Now, the bank is benefiting from higher interest rates. HSBC has a large depositor base as a major retail and commercial lender in Britain and Hong Kong. (HSBC is based in London but generates most of its income in Asia.) Like just about every other big bank, HSBC’s net interest margin—or the difference between what it pays depositors and what it earns on loans to customers—has improved over the past 18 months as central banks have raised policy rates to bring down inflation. Profit nearly quadrupled in the first quarter from a year earlier to $10.3 billion, its highest quarterly tally on record, according to S&P Global Market Intelligence. Moving forward, HSBC has also reached a key performance target, forecasting a near-term return on tangible equity of 12%, compared to its previous target of 9.9%.
4. IPO Market Awakens from Long Slumber
IPO investors have moved from fear of losing money to fear of missing out. Last week, Oddity Tech, the parent of direct-to-consumer beauty brand Il Makiage, staged a wildly successful stock-market debut, signaling that after an 18-month quiet period, the IPO market could be on the cusp of a revival. In the past several weeks, the major barriers to a resurgence in initial public offerings have lifted. U.S. stocks are climbing toward new 52-week highs, volatility is down, inflation has eased and, perhaps most important, investors are making speculative bets again. What will determine whether the IPO market returns to a roar is now more about whether stewards of private companies want to make the transition to public ownership.
“It’s supply crimping the IPO market, not demand,” said Daniel Burton-Morgan, head of Americas Equity Capital Markets Syndicate at Bank of America. “Does that mean post-Labor Day we see a more normal IPO market? Maybe. Or it could take another quarter. But at this juncture, investor demand is not the issue.” The slow period allowed many startups to do what two years ago seemed unthinkable: cut costs and pivot toward a goal of quickly reaching profitability. That means the pipeline of companies eyeing U.S. offerings is stronger than before the slowdown, bankers say. The fall looks to be busy. The biggest offering of the year is set for September. British chip designer Arm is looking to list shares as early as mid-September, according to multiple people close to the deal. Arm will likely target a valuation of more than $50 billion. And there are more major listings in the offing.
Plenty of private companies are still holding back from public markets. Stripe raised more than $6.5 billion privately earlier this year, and the fintech company is no longer aiming for a 2023 stock-market debut. Reddit, also long discussed as a 2023 IPO candidate, isn’t planning on listing its shares soon. Some companies, including digital advertising firm Aleph Group, have withdrawn their IPO filings with the Securities and Exchange Commission, worried about how the economy will fare in the balance of the year. Still, there are signs that animal spirits are returning to the IPO market. Investors who attended Oddity’s roadshow earlier this month were surprised by the fervent tone that felt a lot like the boom times, one fund manager said.
5. CVS Beats on Earnings and Revenue
CVS Health on Wednesday reported second-quarter earnings and revenue that beat expectations, as the company slashes costs and lays off thousands of employees. CVS has implemented a cost-cutting program as it pushes deeper into healthcare services in the wake of its $8 billion acquisition of Signify Health and its $10.6 billion purchase of Oak Street Health.
The healthcare giant posted net income of $1.91 billion for the quarter, or $1.48 per share, a 37% decline from the same period in 2022 when CVS reported net income of $3.04 billion, or $2.29 per share. Excluding one-time items, CVS reported $2.21 per share for the period. The company booked revenue of $88.9 billion for the quarter, a 10% increase compared with the year-ago period. CVS maintained its full-year adjusted earnings guidance of $8.50 to $8.70 per share, after slashing its projections by 20 cents last quarter due to costs associated with its recent acquisitions.
The company’s health services segment generated $46.22 billion in revenue, a 7.6% increase compared with the same quarter in 2022. The division includes the pharmacy benefit manager CVS Caremark and health-care services delivered in medical clinics, via telehealth, and at home. CVS’ retail pharmacy division generated $28.78 billion in sales, also 7.6% higher than the year-ago period, driven by increased prescription volume. The number of prescriptions filled rose 2.4% on a 30-day basis compared with the same quarter last year, excluding Covid-19 vaccinations. Same-store prescription volume jumped nearly 5% compared with the same quarter in 2022, excluding Covid vaccines. The company’s health insurance segment generated $26.75 billion, a 17.6% increase over the second quarter of 2022. That division includes Aetna plans for the Affordable Care Act, Medicare Advantage, Medicaid, and dental and vision. The share of CVS is up 3.88% on Wednesday.
6. Trump Is Indicted in Federal Probe of His Efforts to Reverse 2020 Election
Donald Trump was indicted Tuesday in an unprecedented criminal case accusing the former president of trying to subvert the will of American voters through his attempts to cling to power after he lost the 2020 election.
The indictment by a federal grand jury in Washington, D.C. charges Trump with four crimes, including conspiring to defraud the U.S., obstructing an official proceeding, and conspiring against the rights of voters for his actions that culminated in the Jan. 6, 2021, attack by his supporters on the U.S. Capitol. The indictment charges Trump alone but describes six co-conspirators working with him, including people identifiable as Rudy Giuliani and several other lawyers who worked with him to contest the 2020 election results. Former President Donald Trump pleaded not guilty Thursday to charges that he conspired to overturn the results of the 2020 election to remain in power, appearing in a federal courtroom block from the U.S. Capitol that was stormed by his supporters on Jan. 6, 2021.
Sources:
(1) www.bloomberg.com
(2) www.factset.com
(3) www.wsj.com
(4) www.nytimes.com
(5) www.barrons.com
(6) www.cnbc.com
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Economic forecasts set forth may not develop as predicted.
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Investment advice offered through Private Advisor Group, a registered investment advisor and separate entity from The Legacy Foundation.
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