While the downgrade is certainly significant, it’s important to put it in context and understand its effects on various aspects of the economy and investment strategies.
The Nature of the Downgrade: A Reflection on Governance and Debt
Fitch’s downgrade, only the second in US history, is a reminder of the challenges the nation faces in maintaining fiscal discipline. The agency cited “repeated debt-limit political standoffs and last-minute resolutions” as contributing factors to its decision. This mirrors worries that were voiced in 2011 during a comparable downgrade orchestrated by Standard & Poor’s, which occurred after a period of partisan conflicts surrounding the increase of the debt ceiling.
The rationale underlying these downgrades highlights the erosion of confidence in fiscal management and the mounting debt burden fueled by factors such as tax cuts, increased spending, and growing costs of social programs like Social Security and Medicare.
Immediate Effects: Stocks, Bonds, and Borrowing Costs
The downgrade’s impact on financial markets was felt swiftly, with stocks experiencing a notable decline. The Nasdaq Composite, S&P 500, and Dow Jones Industrial Average all posted losses in response. Bonds also faced volatility, as yields rose following the downgrade announcement.
A downgrade carries the potential to raise the US government’s borrowing costs due to perceived default risk. This can lead to increased interest payments on new debt issues, potentially deepening the debt burden. Given that the US has surpassed a record $25 trillion in outstanding Treasuries, the government’s interest payments are already substantial.
Currency and Market Volatility
In recent times, market volatility has become a frequent phenomenon, driven by a range of factors including the global COVID-19 pandemic, lockdown measures, widespread savings accumulation, and a decline in consumer spending. This intricate chain of events has created a unique economic landscape. In response to the inflationary pressures, central banks increased interest rates. The intent behind raising interest rates was to manage inflation and stabilise the economy. However, this adjustment in interest rates had its own set of consequences.
Simultaneously, the world witnessed an escalation in geopolitical tensions, notably the Ukraine war in February 2022. This event introduced an additional layer of uncertainty and disruption to the global economic landscape, causing word food prices and other commodities to reach an all-time high.
This week´s U.S. credit rating downgrade could also devaluate their currency, as foreign investors might choose to sell their holdings, leading to an increase in the supply of the US dollar in foreign exchange markets. In addition, stock markets could experience short-term volatility, as seen during the 2011 downgrade.
Interestingly, the downgrade has led to a shift in the correlation between Treasuries and stocks. Traditionally considered a hedge, government debt’s correlation with equities has increased, challenging its historical role as a diversifier.
Investment Implications and Opportunities
The adjusted relationship between Treasuries and stocks underscores the need for adaptive investment strategies. With yields on the rise, the equity-risk premium, indicating the added reward for holding stocks over bonds, has decreased. This trend has drawn attention to alternative diversification options.
United Advisers Group (UAG) suggests that, especially during times of market volatility, investors rely on high-quality multi-asset actively managed funds. These funds are designed to promptly adapt to shifting market conditions, providing a level of agility that can be beneficial in uncertain times. The “Magnificent 7”, generally includes prominent tech giants like Apple, Amazon, Microsoft, Google (Alphabet), Facebook (Meta), Tesla, and Netflix are usually included in the funds investing strategy due to the substantial market capitalization, innovation, and widespread influence on various sectors of the economy of these companies. Additionally, these funds can also invest in diverse assets, including corporate and government funds, as well as valuable metals such as gold and silver, that are currently experiencing a surge. A diverse portfolio can optimise returns.
Future Outlook and Adaptability
While the credit downgrade raises concerns, it’s vital to approach the situation with context and perspective. Experts note that the downgrade’s impact is less pronounced than the 2011 event, and the likelihood of US default remains exceedingly low. The resilience of US Treasuries as a safe investment persists, supported by the country’s reserve currency status.
The immediate economic slowdown resulting from the downgrade is not enough to trigger a recession, according to experts. Economic data remains strong, and the potential for a “soft landing” scenario is suggested by robust GDP numbers and the stability of the consumer and labor market.
UAG’s economic outlook progressively evolves from a super cautious approach in 2022 to a cautious-optimist stance in 2023 and, ultimately, a more optimistic perspective towards 2024. These viewpoints reflect our assessment of the prevailing economic conditions and its expectations for the coming years, balancing both caution and hope based on various influencing factors. It’s important to note that nobody knows the future, and the year 2024 is expected to see massive changes influenced by significant events such as the upcoming UK and US elections. These events could introduce considerable shifts in economic and geopolitical dynamics.
In conclusion, the credit downgrade serves as a reminder of the dynamic nature of financial markets. Investors must remain informed and adaptable, adjusting their strategies in response to evolving trends. As the economic landscape continues to evolve, opportunities and challenges will arise. A strategy commonly adopted is to stay invested, as long-term fidelity will produce a win and is more important than market timing in the short-term.
This communication is for informational purposes only and is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice from a professional adviser before embarking on any financial planning activity.
