Rating agency Fitch downgraded the U.S. government’s longer-term credit rating to AA+ from AAA. This was the second downgrade in the nation’s history. The first came in August 2011 from S&P Global Ratings after a government standoff over the debt ceiling. The agency cited “the 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’ rated peers” as reasons for the downgrade.
- U.S. debt was downgraded for a second time in history, but we do not expect this to have much impact on the bull market or the strength of the economy.
- Last week may have marked the start of seasonal volatility, but near-term weakness offers an opportunity to buy as prices are likely to rise later in the year.
- Payrolls grew 187,000 in July and have averaged 218,000 over the past three months. That is faster than the pre-pandemic pace.
- The unemployment rate dipped to 3.5%, indicating a very strong labor market.
- Wage growth is running strong, and that’s boosting incomes ahead of inflation.
- The economy is growing and normalizing.
Not surprisingly, many in Washington disagree with the decision. U.S. Treasury Secretary Janet Yellen said she strongly disagreed, calling the decision “arbitrary” and based on outdated data.
It would be tough to call this a huge surprise, given three months ago Fitch put the U.S. on watch for a potential downgrade. Moody’s is the final major ratings agency to rate the country’s debt at AAA, so it could be next.
However, while 11 countries now have higher-rated debt than the U.S., few people believe in that ranking. The U.S. still holds the world’s reserve currency, and U.S. Treasuries are widely considered the safest asset in the world. The first downgrade in 2011 did little to change that, and we don’t expect the second downgrade to either.
Without getting too technical, Fitch cited growing debt as a concern. But overall debt relative to gross domestic product (GDP) has been trending lower (improving) for nearly three years.
Last-minute debt ceiling negotiations in Washington also generate concern, but it is notable that over the past two years Congress has passed three major bipartisan deals, including the Bipartisan Infrastructure Deal, the CHIPS and Science Act, and a spending deal to avoid a debt ceiling breach earlier this year. Another reason Fitch cited for the downgrade was the “erosion of governance,” but we don’t see that as an issue.
Lastly, the economy continues to surprise to the upside (discussed further below), so the timing of this downgrade is questionable.
Seasonal Volatility Right on Cue
We noted last week that after a historic start to 2023 for stocks, seasonal weakness was possible. Right on cue, stocks experienced their worst week since early March and the regional banking crisis. To be clear, we remain overweight equities, but we believe a modest pullback in August or September is possible.
In fact, the day of the downgrade the S&P 500 fell 1.4%, marking the first 1% decline in more than two months. After a five-month win streak and historically low volatility, we think investors should buckle up for possible big swings. The good news is that, historically, when the S&P 500 goes more than two months without a 1% decline and then finally has one, higher prices typically follow. In fact, since 1980, the S&P 500 was higher a year later 26 out of 27 times and up a very impressive 14.8% on average. While some of the near-term returns can be rocky, longer-term better returns are typically normal.
The Economy Is Normalizing
The economy created 187,000 jobs in July, which is slightly softer than the 200,000 that economists expected. The last couple of months were revised lower, which is why it is helpful to review the three-month average. That figure is now 218,000, which is stronger than the pre-pandemic average of 183,000.
In short, job growth remains strong. Some may view the lower-than-expected jobs numbers as heralding a recession, but more likely they are signs of economic normalization not weakness. The report aligns with our mid-year 2023 outlook, which was titled “Edging Closer to Normal.”
The private sector created 172,000 jobs in July, up from 128,000 in June. On a sector level, job growth this year has been driven by non-cyclical areas, such as health care, education, and government. These sectors had lagged in the early recovery, accounting for just 13% of jobs created in 2021 and 25% in 2022. Over the first seven months of this year, they have accounted for more than 50% of jobs created. July didn’t buck that trend, with health care seeing 100,000 jobs created. Government jobs were on the softer side, rising 15,000 in July versus an average of 53,000 between April and June.
The cyclical areas, especially construction, manufacturing, and leisure and hospitality, remain on the softer side, with job growth totaling to 34,000. So far this year, these sectors have accounted for about 20% of job creation (not exactly “weak”), versus 36% in 2022 and 43% in 2021.
Again, the theme is normalization.
The Best Labor Market Since the Late 1990s
The unemployment rate fell to 3.5% in July, not far from the 50-plus year lows of 3.4%. Amazingly, the unemployment rate is slightly below where it was in June 2023 when the Fed began its aggressive rate hikes.
The unemployment rate can be impacted by people leaving the labor force (technically defined as those “not looking for work”) and an aging population. Reviewing the employment-population ratio for prime age workers, i.e., workers aged 25-54 years, provides a more accurate picture. This measures the number of people working as a percentage of the civilian population. It can be considered the opposite of the unemployment rate, and using prime age avoids the numbers being skewed by demographic shifts.
The prime-age employment-population ratio remained at 80.9%. That is higher than at any point since May 2001 when it was falling. This is the best indication that the labor market remains healthy and probably in the best shape it has been since the late 1990s.
Bottom Line: All Signs Point to a Strong Economy
The U.S. economy runs on consumption, and for that we need income. Encouragingly, income growth remains strong and is running ahead of inflation. In fact, wage growth rose 0.4% in July. Monthly numbers can be volatile, but the three-month annualized pace is 4.9%.
Combine strong wage growth with strong employment, and we see strong income gains across the entire economy. Over the last three months, overall income growth for all workers has run at a 5.3% annual pace. Meanwhile, headline inflation is running close to 2.0%. The difference between the two indicates how fast incomes are growing after adjusting for inflation, which has run above a 3% annual pace over the past three months.
That is the simplest measure of underlying economic growth and provides a positive signal. Normalization is not the same as weakness.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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