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June 5, 2023 - Will the US lose its AAA rating (again) ?



A catastrophic event has been averted, with the last minute agreement on the US debt ceiling. The bill passed both chambers of the Congress, with disagreements by the extreme wings of both parties, but with the help of the vast majority of democrats and republicans. This means that starting today the Treasury will increase again the debt of the US government ! And it will start issuing bonds, immediately, to replenish the TGA (treasury general account) whose cash balances had reached less than 50bn$ last week and it was at 500bn$ just a few weeks ago. The estimated amount to be raised is 500-750bn$ , which could have implications to bank deposits , as clients could move cash to these short term bonds (1-2 month maturities) and drain the liquidity of banks.


But the rating agencies like Fitch, Moody's and S&P will also monitor the situation closely as they have done in the past. In August 2011, the S&P rating agency downgraded the US debt to AA+, from AAA, just a few days after a similar situation had taken place with the debt ceiling. Twelve years later, Fitch downgraded the outlook of the US debt to negative two weeks ago, which is a prelude, most of the times, to an actual downgrade of the rating. And at this stage we should highlight that the Debt to GDP ratio of the US was at about 95% in 2011, when the downgrade happened and today it is at 130%, closer to that of Italy's. But before you make the decision to start selling your US treasury bonds, we should also note that these bonds could actually rally, as they will still be considered "safe heaven", during an equity market meltdown. On the other hand, the USD might be the one to "take the hit" if the market ever questions the sustainability of the US debt situation. Printing money to finance the maturing debt is a solution we have seen before ( ... in emerging markets).

Global manufacturing continues to be in recession, according to the PMI indices. China's May PMI (purchasing managers index) fell to 48.8, down for a third consecutive month and back below 50.0, after a brief surge to 52.6 in February. At the same time, the Chicago PMI collapsed to 40.4, close to the low of last year and just 10 points above the pandemic low in May of 2020. The situation is similar in Europe, as in the rest of the developed world. The services economy and primarily the travel and leisure industries are still performing strongly, in the aftermath of the pandemic period, boosting jobs and GDP growth, of which they comprise a large percentage. Manufacturing is in recession and the overall outcome is sluggish growth, amidst high inflation. The next 6-9 months will be crucial to see whether services will move lower and dive eventually into recession too, as spending will be hurt by high prices and loss of income or manufacturing can be revived and the economies will embark in a new up cycle. For the moment, equities embrace the second scenario.


Eurozone May inflation surprised positively. The headline CPI was announced at 6.1% on a yearly basis, down from 7% of last month. The Core CPI which excludes food & energy prices, fell to 5.3%, down from 5.6% last month. Looking into the details, we see the recent trends continuing, ie. consumer goods inflation is cooling fast, but consumer services' prices (and especially those associated with leisure and entertainment continue to be sticky). Overall, the direction of travel for inflation is clearly south, as we are falling from a very high number of almost 11% back in October of last year. And we should note that the 6% current inflation is where we were just as the war in Ukraine broke out. But at the same time, the ECB's target is at 2%, or thereabout, and although we can see inflation falling even further to 3-4% in the next 3-6 months, any further drop close to the 2% target will be hard to achieve without a major slowdown in economic activity or recession.


The US labor market presented a mixed picture in May. The (widely followed) monthly headline number of non-farm payrolls increased by 339k, which was much better than expected (+185k). But according to the household survey, the number of unemployed people increased significantly by 440k to 6.1mn people, which made the unemployment rate jump to 3.7% from the low of 3.4% of the previous month. To put this 0.3% rise in perspective, economists say that a 0.5% jump in unemployment rate in a single month usually leads to a recession. The 3.7% unemployment rate is the highest since October 2022, but it would take a number closer to 4.5% or higher to make the case for a recession a done deal. On positive news for inflation, the yearly average change in wages dropped to 4.3% from 4.4% the previous month.


Equities moved higher, primarily in the US, where the artificial intelligence hype seems to have no end. The S&P500 added 2% to this year's performance and solidified its position above the 4200 level, which had "haunted" it until now. Technically, it looks poised to continue its ascend as long as traders and investors are willing to look past the current flashing red lights and bet on the scenario which calls for a falling inflation to 2% without a recession. European equities seem to have lost their momentum as they lack the adequate number of companies associated closely or remotely with AI. Most European indices were flat for the week. Asian equities appear to be on the verge of an awakening with Hang Seng's jump of 4% on Friday setting the ground for more gains perhaps.


The bond market moved slightly higher despite the good equity mood and the decent macro data. Given the rally in equities and the complete lack of any worry towards the US regional banks situation as well as the recent hawkish communication by FED officials, bond prices were remarkably resilient and moved higher (yields lower). The US 2-year yield finished the week at 4.52%, down from 4.60% last week, while the move in the 10-year yield was similar (down to 3.70% from 3.80%).


Saudi Arabia announced a unilateral cut of oil production, by 1mn barrels in July in an attempt to show the world that it can move independent of OPEC, in order to protect prices. The WTI Crude prices jumped to about 72$ on the news.



Chart of the Week : Can history repeat itself ?


The chart above shows the performance of the S&P500 in 2011, which was the last time that a divided Congress approved the debt ceiling increase. The red arrow on the left shows the date of the deal and the arrow on the right shows the date when the S&P rating agency downgraded the US debt, losing its AAA rating. It is interesting to see that the market collapsed by more than 10%, after the deal was signed and passed through Congress, contrary to the intuitive thought that good news would spill into a rally, especially given the previous weakness of the market, since mid-July. Even more worrisome, the market rebounded in August and September only to find its low in early October. October is the month of the lows, traditionally, and we saw that this happened also last year, with the S&P500 reaching the low of 3580 on the 14th of that month. It is interesting to see whether history will repeat itself and a sell-off happens in June - July and the low of 2023 is going to be registered in October.


Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.

• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.

• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.

• Sources: Chart of the Week : Factset

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