Late breaking news:
On August 1, rating agency Fitch downgraded the credit rating of US Treasuries from AAA to AA+, citing concerns with the country’s growing debt burden and political dysfunction that has resulted in repeated debt limit standoffs. This isn’t the first time a rating agency has downgraded US Treasuries. In 2011, S&P cut the US government’s rating to AA+ after the big debt limit showdown. That downgrade resulted in some short term volatility but had no long term impact on either the markets or the government’s ability to borrow.
Fitch’s downgrade sparked a selloff in both stocks and bonds, tapping the brakes on the year-to-date market rally. If history serves as a guide, the downgrade is unlikely to have a long-term impact on markets or government borrowing. As I reference below in this month’s commentary, everything’s relative. While US Treasuries are rated AA+ by Fitch and S&P, relative to other sovereign country debt, it’s still among the highest. A handful of countries such as Australia, Germany, Singapore, and Sweden still have AAA credit ratings. But US Treasuries (and the US dollar) are still viewed as the world's safest and most liquid asset — a safe haven when global markets are in turmoil. And the likelihood of the US defaulting on its debt is still highly unlikely. That said, the downgrade serves as a needed fiscal wake-up call.
And now onto our regularly scheduled programming:
Like millions of other travelers, I spent most of July on the road, partly for work, partly for family gatherings. I passed through ten domestic and international airports, some a few times through — and I was clearly not the only one. Every airport I flew into or out from, regardless of whether it was early morning, late at night, a major international airport or a small regional hub, was overflowing with travelers.
I felt like a salmon swimming upstream, constantly dodging hundreds of people to get to my gate. Even my carry-on luggage protested by conveniently jettisoning two of its wheels toward the end of what-I-swear-was-at-least-a-half-mile trek from the gate to ground transportation. (But that’s a story for another time.) If crowded airports offer any kind of sign about the health of our economy, I’d say it seems strong and resilient. The markets sure think so.
Better than expected
As of late July 2023, company earnings have been better than expected, and annual inflation has cooled to 3%, down more than 3x from a year ago. To date, the NASDAQ is up a whopping 37.1%, the S&P is up 19.5% (almost reversing its 2022 loss of 19.6%), and the DJIA is up over 7%. The market rally which was highly concentrated in technology stocks earlier in the year has now broadened to include stocks in different sectors and across smaller companies. US GDP grew at a healthy 2.4% over last quarter. And with half of US states reporting record low unemployment rates, investors are optimistic about a soft landing for the economy: slowing growth without triggering a recession.
As largely expected, the Federal Reserve raised rates by another quarter point in July. While stock markets rallied through it, cash and bond yields rose, making them even more attractive to investors who had shunned them for decades. It’s important to look beyond absolute yields and examine relative yields, especially as they compare to historical averages. One comparison that investors often use to determine how well they’re being compensated to hold (higher risk) stocks relative to (lower risk) bonds is called the equity risk premium. The equity risk premium measures the difference between stocks’ earnings yield and bond yields. As of late, that premium has been shrinking.
The chart below illustrates the market’s earnings yield (using the S&P 500 as a proxy) and the equity risk premium (the lower line, which represents the spread between the 10-year US Treasury yield and the market’s earnings yield) since 1985. Note how the equity risk premium has shrunk to 1.1%, after fluctuating between 4–6% since 2009.
While investors expect the premium to revert to historical averages at some point, for now, lower risk bonds and risk-free cash (e.g. FDIC-insured savings accounts) look awfully attractive in both absolute and relative terms. That certainly explains the week over week outflows from equity mutual funds and inflows into bond funds. And for investors in high-tax states like California and New York, some long-term municipal bonds offer tax-equivalent yields nearly as high as the long-term average stock return.
Similarly, spreads among different bond asset classes are narrowing. The bar chart below shows the current yields of different kinds of bonds: US Treasuries, investment grade corporate bonds, and high-yield corporate bonds, among others. Yield to worst is the lowest possible yield of that bond type, assuming no default.
While yields have risen across the board due to the Fed’s rate increases, they haven't all gone up by the same percentage. The average spread since 2009 between Treasuries and high-yield bonds is about 5.3%. That’s the additional yield investors receive for taking on the credit risk of high-yield corporate bonds. Today, that spread has shrunk to 4%. Similarly, taking on the risk of higher quality corporate bonds (e.g. investment grade) yields only an extra 1.1%, compared to an average since 2009 of almost 2%.
It wasn’t that long ago that T.I.N.A. reigned true — investors felt they had few alternatives for generating financial returns other than stocks. Today? Not so much. Bonds and cash are enjoying the limelight. Stocks may continue their rally into 2023, or maybe not. Rates may continue to rise, or stay steady. Yields on cash might stay high, or come down. Just as this year’s rally so far has taken investors by surprise, we don’t know what’s in store for the second half of 2023. A diversified portfolio of stocks and bonds — and cash and alternatives — will help investors stay invested regardless of what happens.
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