Fitch Downgrade Bears Little Resemblance to 2011

Jeff Buchbinder (00:00):

<Silence> Hello everyone, and welcome to the latest LPL Market Signals. Jeff Buchbinder here with my friend and colleague, Jeffrey Roach. How are you today, sir?

Jeffrey Roach (00:10):

Hello. Hello. It is a Monday as we're recording it here. And so far the week has started out well, <laugh>, we got a few more days to go though, right?

Jeff Buchbinder (00:19):

Few more days to go. Well, hopefully the retail sales data or the Fed don't ruin what so far is a good week. So thanks for joining, Jeff. Sorry, we took the week off after our national conference out in San Diego. Took a break and now we're back with you. So, thank you, Jeff, for joining. Here's our agenda. We're just going to recap last week, it was a really interesting week because of the move higher in interest rates. Next, we're going to talk about the Fitch downgrade. We would've talked about this last week, certainly, because it happened on August 1. But we'll cover that. And we actually wrote a Weekly Market Commentary on that topic, on the U.S. debt situation. Certainly, an important but maybe not so pleasant topic. And then last, I already teased it, right?

Jeff Buchbinder (01:10):

Retail's the big story of the week with the Fed minutes, and next week is Jackson Hole. So let's get into it, Jeff. Here's the headline for the week—Stocks Struggle with Rising Rates. You mentioned it's Monday. It's Monday, August 14, as we're recording this. And these returns are through Friday August 11. So we had a little bit of a down week for the S&P down 30 basis points. Not much. The weakness in the Nasdaq though, stands out. And so, you know, on the one hand you might think, well, techs had such a great run, it needs to pull back. Right. Valuations are high, and certainly some of the tech leaders, and we would generally agree with that sentiment, but I think rising rates was really more of the story last week.

Jeff Buchbinder (01:56):

We'll show you a chart of the te10-year here in a minute, but it was a pretty big move, you know, up to up near last year's highs on the 10-year. Part of this is related to what Fitch highlighted that you know, the U.S. debt situation isn't getting any better, but it's also related to the soft landing narrative, maybe catching hold. So we had some losses in the bond market, and then we had, which we'll show you in a minute, and then we had some losses in the stock market. Anything else here jump out at you, Jeff, to highlight?

Jeffrey Roach (02:33):

Well, it is interesting, you know, we look at one week, one month, three-month, six-month, you know, and you, and it gets a little bit dangerous when you try to tell a story in shorter timeframes. But, you know, after the CPI and Thursday last week, and then the University of Michigan sentiment survey on Friday, it's interesting. Thursday, Friday, some moves within cyclicals. Now, that didn't necessarily hold up for the whole week, but I, you know, I think the markets are still trying to figure out, you know, the data is fairly solid. There's not a lot of hard data that's confirming the story that eventually the consumer will run out of money for the spending splurge they're doing. The survey data is what people are holding onto. People like me, for example, <laugh>, that eventually the bill comes due. And so it's been tough. Markets seem like that soft landing might happen. Inflation is cooling, but really that last mile, getting down to the 2% might be a challenge. And higher rates certainly been a little bit of a damper.

Jeff Buchbinder (03:43):

Oh, no doubt. Something else that's been a bit of a damper is China, right? The reopening has been a big disappointment. They're struggling with property real estate crisis. So you saw China's market lose some ground last week. You saw weakness in industrial metals, very China-tied. So that's certainly something we're watching. LPL Research continues to be underweight emerging market equities. The so here's bonds and commodities, and you see the industrial metals index down 3.5%, you know, coppers down this year. The energy sector actually is really natural gas driven. Crude oil didn't move much last week. It was really a natural gas story, but that helped drive energy sector gains, you know, the top performer last week. And I guess on the bond side, I mean, other than just losses in high quality bonds as rates rose, I think the resilience of high yield is interesting.

Jeff Buchbinder (04:42):

Of course, high yield offers, attractive yields. Maybe that speaks to the you know, resilience of corporate America. A theme that we have heard a lot about during earnings season, certainly. You know, high yield's not an area we're, we're focused on. We like preferred securities better within the fixed income universe in terms of credit. But I think high yields resilience is notable. So let's turn to the stock market here, Jeff. This is the S&P 500, and I got some support levels from our chief technician, Adam Turnquist, and drew some lines on here. I think, you know, the first takeaway here is that there's a lot of support for the S&P 500, just a little below where we're at. We're a little bit above this as we're recording. This is Friday's close 4,465.

Jeff Buchbinder (05:35):

The, you know, the support levels from recent highs and from the, you know, sort of support from the maybe the June pullback. There's a number of levels here that could keep us above, let's say 4,350 for a while. You know, maybe a 130 S&P points down. But we think actually this pullback could go a little further, you know, so maybe we'd be watching the 4,200 level for an ultimate low potentially, that would probably be a dip that we would be buying. So we'll see how far it goes. I mean, the next support level is the 50-day moving average around 4,440. But we've kind of been bouncing around here the last couple of months. The good news when you bounce around is you create support. But of course, the bad news is you don't make any progress.

Jeff Buchbinder (06:25):

So, you know, our neutral equities kind of fits with the technical story. Maybe we need to be sort of choppy and sideways. So let's look at the 10-year yield real fast here. I mean, this is a simple story, right? We are really close to the highs of last fall, and if we break through those, we're going to be at 15-year highs on the 10-year Treasury yield. So this is something that the stock market's going to have a tough time digesting if we keep going higher. Jeff, what would you say you know, is sort of the mix of causes of higher yields? Do you think this is, you know, the market kind of reacting to Fitch? Do you think it's, you know, the digestion of all the Treasury issuance? Do you think it's soft landing or something else? All the above?

Jeffrey Roach (07:11):

Well, you know, I think we make a pretty decent case that it's not Fitch or at least it'll at least shrug it off a little bit, you know, relative to comparing you know, with the S&P downgrade in 2011, which we'll talk about in just a little bit. You know, I think in terms of where you want to rank, you know, the key catalysts for this rise, I think it's that soft landing narrative. I think it's kind of interesting when you think about yields on the 10-year relative to what we're seeing in high yields. We kind of hinted at it on that screenshot a little bit earlier in the slides. It's this unusual period where I think, you know, there might be a little bit of interest for investors to take risk off the table.

Jeffrey Roach (07:55):

We saw that in the equity numbers and the techno kind of support levels. Perhaps there might be a little bit more interest for investors to take a little more equity risk off the table. But I think there's a little bit of that unknown about you know, coming through 2023 things look very strong. We're slowing down, no doubt, especially as you look at labor market. But it's that unknown about what the rest of Q3 and Q4 look like. And fixed income investors need to be compensated for that risk.

Jeff Buchbinder (08:33):

Oh yeah, absolutely. I mean, we like the bond market as much as we have in a very long time. So that means that we are, you know, comfortable with the yields here. If we thought yields were going to go much higher than this, we certainly wouldn't be as comfortable with bonds. So you know, combination of the Fed being close to done or done, and inflation coming down we think we'll put downward pressure on rates. But in the very short term, sure, we got a lot of Treasury issuance to digest. And then we have you know, the budget concerns that were raised by Fitch. So, you know, we don't want to sound bearish here because we're neutral, right? Neutral equities is not negative. Actually, this slide probably supports being fully invested because these drawdowns here are not, you know, particularly severe.

Jeff Buchbinder (09:26):

So this is a study that Adam Turnquist did looking at how big drawdowns tend to be after a strong start to the year. So he ran this on August 11, broke the year to date returns down by deciles, and then looked at the maximum pullbacks that you get within each decile. So, we're in decile two, I guess, you know, up 16, 17% for the year. The average drawdown is only six and a half. That's, I mean, heck, we're almost halfway there already, and people haven't even noticed this pullback. It's been so limited, right? So, you know, maybe we have a little bit bigger than that. You know, to get to 4,200, you would need a little bit bigger pullback. The point here is we can still have a solid gain for the year. We can end the year higher than we are, you know, right now, but still have a high single digit pullback. So when that high single digit pullback potentially comes you know, don't be too alarmed. Yeah. I think this is really good message to pan out to investors actually kind of related to this, the average drawdown in any given positive year is 12%. Right? I bet that's bigger than a lot of people would guess based on data back to to 1950.

Jeffrey Roach (10:45):

Well, Jeff, I think you hinted at it earlier. I think when you look at the numbers and you look where we are and the path on which we traveled since January this year to where we are today, I think it does make the case for staying invested. And I love that title you did, I think it was a blog post maybe several weeks ago now, where we moved to a neutral relative to benchmark waiting for equities. But that wasn't, that's not a negative view, right? There's, it's just a management of the risk and the choppiness. And I think the other thing I'd say, you know, it's interesting when the recent drawdown in the last week or so really hasn't garnered a lot of attention, seems like. Perhaps that's because we've developed so much support at these levels where we are S&P 500.

Jeff Buchbinder (11:39):

Yeah, I don't think this pullback went more than like two and a half percent <laugh>. So, it's well, the Nasdaq was a bigger pullback, but the S&P it's been very limited. So, I think the, you know, the soft landing narrative, gaining hold, good earnings season, generally relative expectations, that's been part of the story. But we've also had this steady decline in inflation, right, Jeff? I mean, this is part of the story too, right? That's got investors maybe you know, reversing their calls for another bear market or pulling back on recession fears.

Jeffrey Roach (12:14):

Yeah, I think, you know, one of the things I'd highlight just for our listeners you know, reading from left to right, don't get too concerned about the details of the numbers, just look at your colors right from red to green, except for gas prices, but pretty much everything else red to green, meaning there's an improvement. One of the things, Jeff, I haven't highlighted enough, but I probably need to start beating on this drum, and that is, you know, in 2020 when the Fed held their virtual Jackson Hole summit, that was kind of modified this 2% target, and the rephrasing of it was, it was a long run, 2% average. And so, I think it's just so, it's so helpful to think of that modest tweak, which turns out to be a pretty, you know you know, life changing in the sense that you think about post-Great Financial Crisis.

Jeffrey Roach (13:15):

We've seen core CPI, core PCE deflator, one of the Fed's preferred metrics of inflation, stay below 2%. So when you get it above 2%, and we're still above the 2%, remember that the Fed talks about this long run average. So it's hovering, sometimes it's going to be below, sometimes it's going to be above. So, I think it's a really important point to remember, because we could get to this stage in this current cycle where the Fed pauses, even though inflation is slightly above their 2% target in the near term, because it's about a 2% long run average target. So, you know, people don't think about that enough, I think. But you know, I wanted to highlight the Jackson Hole Symposium from 2020 because I think it preps us well for the upcoming Jackson Hole 2023, which is I think the 24th, I believe, which is a Thursday and goes into the weekend. But important to think about and really remind folks in how the Fed views the inflation target. Key takeaway here, though, just to boil it down, key takeaway is inflation is easing. Hey, look, excluding housing, you know, the latest July CPI numbers 1%. So you know, it's clearly going in the right direction, and we know that the Fed will take a long run average, not just a month snapshot on that inflation read. So that's, that's the key takeaway.

Jeff Buchbinder (14:58):

Yeah, a hundred percent. So, I think something like 90% of the increase in CPI was housing, if I'm not mistaken. I mean, it's, yeah, it's a big housing story for sure. So, thanks for that, Jeff. Let's go into earnings. You know, some of the stuff I've already shared two weeks ago the last time we did the podcast, right? The story has not changed dramatically. You know, we were surprised at how much upside then, we were surprised at how resilient estimates were then. Well, we still are, right? The beat rates, you're looking at the earnings dashboard, 80% earnings beat rate is better than we've seen in recent quarters at this stage. The upside surprises on average are about seven points, similar to last quarter, but certainly I think a bigger upside surprise than most people thought. Coming into earnings season consensus was looking for down 7% S&P 500 earnings.

Jeff Buchbinder (15:53):

If you take out Merck, which is two points, we're down 1.6 now, so that's quite a bit better. We've got a little more ways to go to get the last few companies out, but we're going to be pretty close to flat ex Merck. Then you take out energy, energy is a 7% drag, roughly a little less, but about that. And then you're up, you know, let's call it maybe 6% when all the numbers are in, five to 6%. That's not bad. That's a pretty good underlying earnings power for what is a very tough environment for companies in terms of, in terms of margins. Now, perhaps the most, impressive thing about this is that estimates for the next four quarters have risen. So, we just hold Q2 or I'm sorry, Q3 of 2023 through Q2 of 2024, right?

Jeff Buchbinder (16:45):

Look at those estimates when earnings season started. Look at them again now, they're up 20 basis points. That is extremely rare. So, estimate resilience is actually, that story has even gained steam over the past couple of weeks since we talked to you last. So, I'm very impressed. Corporate America's done a great job of managing margins and we're, you know, back to near 220 in consensus S&P 500 earnings for 2023 when you know, just a few months ago, a lot of people were talking about 200 or 205. There's just virtually no chance we'll be down there that low at this point. So, we're at 213 and we actually think we're now maybe a little bit too low. What do you think, Jeff, to what do you attribute such strong earnings relative to expectations?

Jeffrey Roach (17:34):

Hmm. Yeah, I like what you said, estimate resilience, <laugh>, and I think we've seen it from the firms managing their labor costs. You know, perhaps that's adding a little bit of support here. Of course, the consumer's still been, you know, spending like crazy. So, they have pretty decent markets and perhaps still a little bit of pricing power you know, that may erode just a bit. But certainly, managing costs has certainly been pretty helpful for the bottom line.

Jeff Buchbinder (18:11):

And certainly productivity statistics for Q2 were pretty strong too. Right? And that kind of feeds into the point you just made, right? Earnings have been, which,

Jeffrey Roach (18:22):

Yeah, which actually is a good little bit of a teaser when we talk about, you know, projections into, you know, 2025, 2026 as it relates to budget as a percentage of GDP. You know, we got to keep those productivity numbers high enough in order to support, you know, what we might think in the next couple years. That's just a little bit of teaser <laugh> for highlighting this week's Weekly Market Commentary.

Jeff Buchbinder (18:49):

The segue master right there at work, <laugh>. Well done. So, yes, we're going to talk about the U.S. debt situation. Fitch of course shined a light on this by downgrading the U.S. government debt rating. And then that followed as many of you remember the S&P move in 2011. So, you know, naturally when we got this headline, some people got nervous, we get it, right. The market dropped almost 20% in 2011, and the S&P downgrade was certainly a big part of why. So let's just talk about, Jeff, some reasons this is different. Here you see the 2011 chart of the S&P 500, and you look at that collapse. I mean, it wasn't all the S&P move, right? I mean, that was a challenging time coming out of the Great Financial Crisis. And we had the European debt crisis raging. Remember we talked about Greece all the time, right?

Jeffrey Roach (19:48):

Right.

Jeff Buchbinder (19:49):

We don't talk about it now, except as a vacation destination. But we're not talking about Greek debt and the solvency of the country anymore, thankfully. So, you know, I think the question people might ask is why is this different, right? So, well, I highlighted one or a couple reasons, really, I mean, first we've been here before, Jeff, right? We, you know, we went through this in 2011, so that's a big difference. We don't have the European debt crisis. That's a big difference. Can you highlight some other reasons maybe why we wouldn't expect the market to react this way?

Jeffrey Roach (20:22):

Well, I think about 2011, we were still working through an absolutely massive asset bubble in housing, right? Remember the collapse in housing certainly started in places like Marco Island and Reno and Las Vegas and Phoenix and then eventually, you know, really kind of traveled across the entire country. But, you know, in these years that we're showing on the screen here you know, housing was a huge, huge drag for pretty much most, well, I should, I'd just say across the board for upper income folks, middle, lower class, you know, wherever you find yourself in the income distribution you know, an asset bubble that's popping as it relates to housing, that is a tough, tough thing to work through.

Jeff Buchbinder (21:16):

Yeah. And that feeds into why we were in a deflationary environment then. And now we're in the opposite, right? This is an inflationary environment. Back then, we had the Fed cut rates to zero. We had quantitative easing, what, four rounds of it. You know, that was several years after this before they finished, but we had a lot of QE with the Fed massively increasing its balance sheet. Well, now we're going the opposite direction. They haven't shrunk the balance sheet much post-pandemic, but they have shrunk it a little bit. And clearly, they're pulling back on stimulus, not adding to it. Right. So that actually, that's a good segue to this slide. I'm going to steal your title as the segue master, Jeff, show you the 10-year yield. So here we superimpose the 10-year yield path this time, right, this year versus 2011, and you see going in opposite directions, right? It's totally different environment.

Jeffrey Roach (22:12):

Well, I think, you know, add other really unusual things happening in 2011 in that in the credit space, broader, you know, fixed income markets, thinking about subprime mortgages you know, we don't have that conversation today. We don't have collateralized debt obligations and collateralized loan obligations, all those instruments. And so, you know, it's very, very different. Now granted, you could kind of argue, well, look, housing was a bubble then, isn't housing a bubble now? And I think I'd respond by saying, well, part of the challenge, it's not, we got to high house prices, not because of very easy access to credit, right? Zero down. If you could fog a mirror, you got a mortgage. In this case, you, you have a very tight labor market because people are moving around. Certainly it started during the hybrid work environment that certainly added all kinds of interesting stresses in the market. Then of course, no one wants to move. If you got a mortgage at two point a half percent, why put your house up for sale now? So supply of homes is going to be constricted in the near term. So, it's a lot different. When you look at credit markets, lending markets those are some two, I think, very important variables to look at.

Jeff Buchbinder (23:36):

Absolutely. So, you know, while this Fitch news probably put a little bit of upward pressure on rates, I mean, we, right after the news, I think the 10-year yield moved about 15 basis points over the next few days. So we'll attribute some of the move to that. But, there's clearly more going on. We still think, as I mentioned earlier, that rates are going to find a ceiling here in short order and then move back down into the high threes by the end of the year consistent with what happens historically when the Fed stops hiking rates. So, you know, so now the question is, well, you know, what happens now? Is the U.S. debt problem going to get worse? And can the Treasury afford to pay the service on the debt and all that? Well, the answer, it's a good story now, right?

Jeff Buchbinder (24:22):

Because debt as a percentage of nominal GDP, the interest on the debt for the U.S. government, has actually come down in recent decades because of low interest rates. This number in the most recent quarter was 2.3%. So that is a good number. But as higher interest rates flow through to Treasury coupon payments on the debt this number is going to get worse. If you look at the interest payments relative to tax receipts, it's kind of like revenue. I'll get to this on the next slide a little bit. The revenue the government gets is obviously how they pay the interest. That ratio right now is 13% and rising, and historically, when it gets to 14%, that triggers some tough decisions, or at least tough conversations in Washington. And maybe the bond vigilantes will come out again and push yields higher. So I think this is a good story now, but as we know, if the U.S. government doesn't start addressing this soon, it's just going to get tougher and tougher over time.

Jeff Buchbinder (25:30):

And you know, eventually the market's going to throw a tantrum. Now, you know, I don't know what you think about timeline for that, Jeff. I think it's several years away still. But it's probably less than 10 before this becomes a real problem, right? And that's what we show on this chart. If the government just continues on its spending path, the deficit as a percentage of GDP is going to go from five and a half to seven and a half, right? And at that point, if interest rates are higher, it really becomes untenable. And we'll have to start spending, you know, cut spending. We'll have to do something with entitlements, potentially we'll have to raise taxes potentially, which nobody wants to see. How long before this becomes a problem, Jeff?

Jeffrey Roach (26:16):

Yeah, you know, I think so much of it relates to what's going to happen the latter half of this year, and then 2024. So we know from history going back, you know, to the Clinton years, and prior to that, when we had a federal surplus for a very short bit, you know, so much weighs and relies upon steady growth. And so if we have kind of this short and shallow recession that may show up, but, and if it's a soft landing, whatever it turns out to be, but if it's short and contained, and so by the time you hit the latter half of 2024 or even 2025, there's enough kind of, you know, correction to allow the economy to kind of, you know, restart to something fairly decent. Now granted, you know, we're going to shift down to slightly lower growth path because of an aging population and a shrinking labor force.

Jeffrey Roach (27:14):

But if we have that offsetting influence of artificial intelligence, keeping productivity rates up, you know, maybe that, you know, 2030 and onward graph doesn't look that bad. And I think Jeff, as you and I were talking about this earlier, you look at that gray line, which is deficit as percent of GDP, you know, kind of hitting a little bit of that steep slope there after 2030, that's going to be very difficult to sustain. Probably unsustainable. A lot of it relies on the blips of the next two years. So yeah, it's interesting, just key takeaway I think from this is, you know, it's about pro-growth policies, you know, things that allow the economy to, you know, thrive and have its, you know, reach its full potential if you will. You know, and that's going to be really something that's going to emerge in the next say, 24 months. That'll be very important how the growth path looks like in the next decade.

Jeff Buchbinder (28:19):

Yeah. So, you know, whoever's in the White House in 2024 may, you know, be in a more challenging situation at some point in their next term. You know, especially if they are two termer, which they probably won't be, but we'll see. Too early to speculate on the 2024 election. But this is something that we need to start addressing in the next several years, or it's just going to get tougher and tougher. So good discussion there again Jeff, as you highlighted, this was the topic of our Weekly Market Commentary for this week, which you can find on lpl.com. So let's preview the week and then we'll wrap up here. So Jeff, we got a big week for retail and it's not just the retail sales report that we get on Tuesday, I guess, that'll be out by the time you listen to this, but we also have a number of retailers reporting earnings, right? Including Home Depot, Target, and Walmart. So I think we can debate, maybe we have a different view on this, but I actually think retail is going to be a bigger story this week than the Fed minutes. What do you think? Are you going to take this?

Jeffrey Roach (29:27):

I don't know. So, I guess the reason why I'm taking the other side on that, Jeff <laugh>, is, you know, the minutes I think are going to help us get a little bit of that sneak peek on how the Fed was viewing this emerging trajectory in inflation. How encouraged are they going to be as they reveal, hey, look, you know, the numbers are still too high, but are they happy about the direction? I think that's going to be important for investors long term because, you know, we still have this disconnect, Jeff, that we've had for a very long time about what the markets expect rates might look like, you know, in the next 12 months, and what the Fed has projected rates in the next 12 months. The Feds you know, a lot more hawkish than what the markets think. And so, I think the minutes will kind of help correct those views. We do know dot plots are poor predictors. Fed's dot plot not a good strategy for those that want to put some bets on the table. But that's kind of my argument for why <laugh> Fed minutes are going to take the cake this week.

Jeff Buchbinder (30:41):

All right, you convinced me. I'll give in.

Jeffrey Roach (30:45):

Not that easy. Come on, come on, push back.

Jeff Buchbinder (30:47):

I'll continue to be an obsessive Fed watcher for just a little bit longer. Maybe through Jackson Hole. And then I'm, I'm going to try to pay attention to other things, but obviously the market for the market, the Fed, is very, very important. And so, if we do get hints as to what they might do either in the minutes today or this week, or in Jackson Hole next week that will be certainly very important for markets. So, you know, other than that, it's just kind of the usual monthly cadence of housing data and jobs data and the leading index that we'll watch. But you know, retail and the Fed probably most important, and I think retail's important now because of the pricing power that's needed to maintain margins, right? I mean, we obviously want insight into the consumer and how consumers are holding up that goes without saying, we care about that all the time.

Jeff Buchbinder (31:39):

<Laugh>, right? Consumer spending is about 70% of the economy. But what I think is a little bit unique this time is in a disinflation environment, right? How are retailers going to be able to maintain margins, right? Because they don't have as much pricing power as they had a couple years ago. So we'll be watching that with the big players during retail earnings week. And that'll pretty much bring earnings season to a close, which frankly, I think has bested virtually anybody's expectations. And it looks like the earnings recession will be over next quarter. So with that, we'll go ahead and wrap. Thanks so much, Jeff for joining. Thanks to all of you for tuning in on another LPL Market Signals. I'm glad we could be back with you. And of course we'll be back with you next week for another edition. Thanks so much, and we'll see you then.