Stocks Tumble on U.S. Credit Downgrade: Aug. 2, 2023

Risk-off sentiment is prevailing so far in August, with today’s malaise being driven by yesterday evening’s U.S. government debt downgrade. This morning’s employment report from ADP failed to provide any relief, with turbo-charged job growth and persistent wage increases pushing yields higher as well. The bulk of the job growth was concentrated within services, which are labor-intensive and the primary driver of current inflation trends. Furthermore, the recent move higher in yields occurs just as the U.S. Treasury gears up to issue longer-term U.S. bonds.

Fitch Highlights Fiscal Policy Challenges

Yesterday’s Fitch downgrade of the country’s debt credit rating is having a sour effect on investor sentiment, as it raises tough questions about the foreseeable future. When lowering the rating one notch from AAA, the highest rating, to AA+, Fitch cited the “erosion of government” and the country’s growing cost of servicing debt, with debt expected to grow to 118% of GDP by 2025. In the immediate term, the downgrade is likely to impact markets and interest rates at the margin, but if other rating agencies follow suit, Treasury yields could rise much more materially, which would increase borrowing costs for the U.S. and corporations. For businesses, the higher debt servicing costs could hurt earnings and constrain business investment. The higher financing costs would also cause consumers to reduce spending on larger ticket items such as automobiles that are often purchased with debt. Moreover, when consumers use financing to buy homes, cars or other items, a larger portion of their income would be allocated to servicing their debt, resulting in less disposable income to spend on dining out, traveling and other services. Higher bond yields would also make debt securities more attractive relative to equities, creating a headwind for the stock market. 

Job Growth Remains Above Trend

Employment growth grew strongly in July as the economy added jobs at a faster-than-trend pace. Private sector job growth totaled 324,000, much higher than expectations predicting 189,000 but softer than June’s 455,000 reading. Wage gains remained firm, with job stayers experiencing a 6.4% year-over-year increase, softer than the previous month’s 6.6%, however. While progress across sectors was broad based, the services segments led the month’s growth and supported income strength.  

Job gains were led by the leisure and hospitality, natural resources and mining, information and trade, transportation and utilities industries with additions of 201,000, 48,000, 36,000 and 30,000, respectively. The other services, education and health services, construction, professional and business services industries contributed to progress at more tempered levels. The manufacturing and financial activities sectors shed 36,000 and 5,000 jobs during the period, confirming yesterday’s employment slide in ISM’s manufacturing gauge.

Investor Sentiment Weakens

Markets are getting punished today, with all major U.S. indices down significantly as the credit downgrade weighs on sentiment. Rate sensitive areas are falling the most, with the tech heavy Nasdaq Composite Index and the small-cap Russell 2000 Index down 2% and 1.6%. Market breadth is poor, with all sectors lower except for a pair of defensive categories: health care and consumer staples. Yields are up across most of the curve, as the one-two punch of the Fitch downgrade and robust job growth weighs on the long-end of the curve via credit risk and inflation expectations. Short-end yields and the dollar are higher due to rising Fed tightening expectations, as investors fear that hot data this week and next could put a September hike back on the table. The 2- and 10-year maturities are up 1 and 5 basis points (bps) to 4.92% and 4.10% while the Dollar Index is up 67 bps to 102.64. A significant drop in U.S. inventories is failing to underpin oil prices, with WTI crude down 2.3% to $79.48 per barrel on defensive positioning, the stronger dollar and risk-off sentiment. 

Consumers Balk at Price Increases

Wage increases and a strong labor market haven’t equated to individuals becoming spendthrifts with Kraft Heinz becoming the latest large company to report that consumers are pushing back on price increases. Like many packaged goods companies, Kraft Heinz has increased its prices to maintain margins with higher wages and inflation increasing its costs. In the second quarter, its unit volume sales dropped 7% as inflation weary customers sought lower cost alternatives, including supermarket white label products. The company’s earnings per share of $0.79 exceeded the consensus expectation by $0.03 even though revenues of $6.72 billion missed the consensus forecast of $6.82 billion. Other companies that have faced consumer pushback against price increases include Heineken, Hershey, Mondelez, Unilever, Kimberly Clark, and Pepsi.

Friday Could be a Pivotal Day for Labor Outlook

If the BLS numbers fall short of analyst expectations, investor sentiment may strengthen based on expectations that the Fed may pause its rate hike campaign in September, but a strong BLS report could have the opposite result. I’m expecting the number to come in at 290,000

Today’s ADP numbers depict ongoing tightness in the labor market and the potential for additional wage pressures as corporations like Kraft Heinz struggle with higher labor costs and increased input prices. The outlook for the Fed’s September meeting is likely to be heavily influenced by this coming Friday’s Bureau of Labor Statistics (BLS) job report, which may, or may not, validate the ADP numbers. Last month, ADP reported that downwardly revised 455,000 employees were hired in June while the BLS reported that only 149,000 individuals were hired during the same time period. If the BLS numbers fall short of analyst expectations, investor sentiment may strengthen based on expectations that the Fed may pause its rate hike campaign in September, but a strong BLS report could have the opposite result. I’m expecting the number to come in at 290,000, higher than the 200,000 consensus expectation.

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