Decoding the US Credit Downgrade
Examining the Catalysts and Preparing for the Aftermath
Our short-term indicator turned negative last week but is gradually improving, although it's not positive yet. However, our quant-based medium and long-term risk signals are positive, and we are fully invested.
The chart below shows our long-term signal. We moved our clients to 70% cash in January of 2022 when our signal flipped red, and we started buying back into this market in early February when our signal flipped green.
Here’s a quick refresher on our long-term signal.
Our long-term RISKSIGNAL serves as a stop loss when it turns red and an all-clear signal when it turns green. Essentially, it tells us when to be in or out of the market. This indicator has shown that it can help us outperform the market by avoiding highly volatile periods and major crashes. However, it's important to note that it's not meant to predict major market tops or bottoms. Instead, it reacts to market changes and will always lag behind major tops while missing every bottom intentionally.
The Goal of the Long-Term RISKSIGNAL is to try to capture 70-85% of the market’s upward trend while sidestepping 70-85% of the downtrend.
What is Happening? A lot…
The market is undeniably exhibiting an upward trend and demonstrating strength. However, it's worth noting that the S&P 500 is overextended, suggesting a potential pullback is imminent so we could see another selloff in the coming days.
Temporarily disregarding the macro perspective, the current market pullback will likely be minor and short-lived. This stems from the significant amount of cash that remains on the sidelines. Many investors are noticeably underinvested, and numerous long/short hedge funds have experienced losses this year. This underinvestment situation may serve as a cushion, prompting fund managers to chase performance and thereby lessening the impact of a potential market drawdown.
However, given these market conditions, it becomes crucial to be highly selective when entering new positions and managing risk. It's essential to exercise caution because when a reversal does occur, it will happen fast. Being prudent and strategic in risk management will be key to navigating the ups and downs that lie ahead.
Remember, the key to long-term wealth generation begins with wealth preservation so risk should be managed before, not after, higher volatility hits the markets.
Powell raised rates again by a quarter point last week, to the highest level in 22 years. He also left the door open for more rate hikes in order to get inflation down to their 2% target.
As I have consistently mentioned for over a year, inflation will remain persistently high, granting the Federal Reserve more room to raise rates.
Looking ahead, it wouldn't be unexpected to witness two or more rate hikes in the future. However, whether we reach that point before a credit event occurs remains uncertain.
It's essential to remember that there is a lag effect from quantitative tightening (QT), which should only begin to impact our economy now.
Throughout July, the market witnessed a remarkable absence of both volatility and trading volume, as indicated by the VIX index remaining in the low teens.
However, as we approach the traditionally weaker months of August and September for the stock market, there is a possibility that this trend of tranquility might undergo a shift. Remember, one of our keys to a bottom is to see the VIX spike to 45+ as no bear market has ever ended without a blowout in the VIX.
When the utilities sector, known for its stability and defensive nature, underperforms compared to the broader S&P 500 index, it often serves as a key indicator that bulls are in control. The utilities sector's primary appeal lies in its reliability, making it a preferred choice for investors seeking safety during uncertain times. However, when the bulls are in full control of the market, they tend to favor riskier and more growth-oriented sectors, leading to a relative underperformance of the utilities sector.
The swift halt in the momentum that utilities were building up, resulting in new lows, further emphasizes the strength of the equity bulls. It indicates that these bulls are confident in their ability to drive the market and are willing to take on more risk to pursue higher returns.
However, it's essential to keep a watchful eye on downside risks that might be underestimated by the bulls. While there are indications that recession risk has been pushed back to 2024, there are still warning signs that traditionally precede an economic downturn. These signals can include factors such as inverted yield curves, declining consumer confidence, and weakening economic indicators - all of that is happening right now.
Fitch Downgrades the US Credit Rating
Following the US debt ceiling drama earlier this year, we have once again witnessed a rating agency downgrading the US, reminiscent of the events that unfolded back then. In 2011, it was Standard & Poor's (S&P), and this time, Fitch has taken the made the call.
For months I and others have been saying that a credit event that no one sees is looming in the background and we might be getting closer to that.
Looking back to 2011, when the credit rating was last downgraded by S&P, we witnessed Treasury yields plummet, leading to remarkable gains of approximately 21% in 20-year Treasuries in just a couple of months.
Simultaneously, the S&P 500 experienced a sharp decline of over 15% in about a month, and high yield spreads blowout by 3.5% over the subsequent three months. Moreover, the VIX surged to 48.
The parallels to the current situation are striking, with the catalysts remaining quite similar – a Congressional battle over spending intertwined with the debt ceiling issue, eventually culminating in a rating adjustment. Given these considerations, it is entirely reasonable to anticipate a market reaction that mirrors 2011.
Amidst this backdrop, you are likely to come across many scary and fear-inducing headlines and charts. However, I aim to approach the situation rationally and objectively assess the implications of the US downgrade for investors and the markets.
Fitch downgraded the US because it reflects an “erosion of governance” that has “manifested in repeated debt limit standoffs and last-minute resolutions.” Additionally, the rating agency foresees an economic downturn on the horizon, potentially exerting further strain on government finances.
As you can see from the chart below, US spending on interest payments is inching closer to an annualized $1 trillion. But let us remember, comparing this to your business budget or personal household is not valid when it comes to the US government's fiscal management. Uncle Sam has a money printer at his disposal, a luxury that you and I do not share.
Contrary to a common misunderstanding, the government doesn't need to source funds for deficit spending; the US government is the very source of money creation.
As the currency issuer to the private sector, it operates differently from households or businesses. Deficit spending creates a deficit on the government's balance sheet but simultaneously boosts the private sector's net wealth.
The government can create money for the private sector without relying on existing funds. However, the challenge lies in controlling deficit spending to avoid inflation and resource shortages, much like trying to drink three bottles of red wine without getting a hangover.
US Treasuries, (now rated AA+), maintain their prestigious position as the most globally accepted form of collateral on the globe. Their reputation remains untarnished due to their reliability, liquidity, and solid backing by the US government.
Treasuries serve as valuable assets for banks, to meet regulations, protecting against interest rate changes, and facilitating financial transactions.
The good news, that no one is talking about, is that the Basel regulatory framework, specifically Basel II, established in 2004, doesn't put any weight on the downgrade.
For bonds rated between AAA and AA-, banks don't need to set aside significant capital.
Bottom line, the downgrade doesn’t really matter. While a single event, such as a US credit rating downgrade, may not be the sole cause for a market turnover, it can indeed be a significant factor within a broader sequence of events that could potentially lead to a market crash. It's crucial to view such downgrades as part of a larger context and consider the interplay of various economic and financial factors.
Market movements are often influenced by a combination of events, trends, and sentiments. If a series of unfavorable events were to unfold, it could create a domino effect that impacts investor confidence, market stability, and overall economic conditions.
As we approach the seasonal period when volatility typically rises, it's essential to be mindful of the signs indicating heightened overconfidence and potential risks in the market. Recent developments have increased the conditions for a potential adverse event in just the past week.
It's evident that investors are displaying confidence that a soft landing will happen. This surge in confidence is driving them to substantially increase their equity allocations and even employ leverage at 2X and 3X the risk to chase higher performance. While the market is showing early signs of broadening out, we must remain cautious as I see indications of overconfidence, which often leads to increased leverage and, in turn, can contribute to a potential stock market crash or global margin call.
The number of stocks advancing relative to those that are declining has allocators favoring less concentrated indices like small and mid-cap stocks over bubble-cap tech - this is a good sign to see as it signals that we have positive breadth occurring.
It is important to recognize the prevailing belief that stocks will experience an overbought pullback but quickly rebound to reach new all-time highs. All the necessary factors are in place to support this narrative (until they don’t).
Currently, our focus is on sectors that are in line with the ongoing market cycle and global macro trends, such as:
US Equity Sectors: Health Care, Aerospace & Defense, Home Construction, and Tech
Other sectors to keep an eye on this quarter: Utilities, Energy, Industrials, and Consumer Discretionary
US Treasuries: While Treasuries prices should continue to fall while the Fed raises rates, we will start incrementally adding to our Treasury positions in preparation for the flight to safety trade.
Emerging Markets: India's domestic demand, business confidence, and industrial production are rising, leading to forecasted growth acceleration and expected reflation through year-end.
Global Equities: Gold, Gold Miners, Silver, and Uranium
International Equities: Japan, South Korea, Brazil, and Israel
If the long-term Ivory Hill RISKSIGNAL turns red, we will not hesitate to increase our cash levels as sticking to our rules at this point in the cycle is more crucial than ever.
As we draw the curtains on this edition, I want to remind you of the timeless wisdom from the late Charles Dow, dating back to 1900: "And remember - the one fact pertaining to all conditions is that they will change."
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