In recent months, the United States (US) debt ceiling made headlines, with a deal finally reached on 1 June 2023. While everyone expected parties on the opposite side of the floor to eventually reach an agreement, even if it was at the eleventh hour, what they weren’t expecting was this week’s debt-rating downgrade, handed down by ratings agency, Fitch.
Key themes for this week include:
- US debt rating downgraded to AA+
- Soaring treasury yields dampens stocks
- Diminished risk appetite weighs on commodities
- Dollar basks in safe haven demand
BIDEN ADMINISTRATION BLASTS RATINGS AGENCY
Amidst concerns over the mounting US deficit and its implications, Fitch Ratings agency made an unexpected move by downgrading the US debt rating from AAA to AA+. A deficit occurs when a country’s expenditures exceed its revenue, leading to increased borrowing to cover the shortfall. Over the past two decades, the US has experienced what many consider to be a steady deterioration in governance standards, resulting in a rising deficit.
In the context of this downgrade, the main contributing factor can be deemed to be the manner in which lawmakers engaged in last-minute negotiations on a debt ceiling deal, putting the nation at risk of its first-ever default. However, the attack on the US Capitol building, organised by a pro-Trump mob calling themselves “Stop the Steal”, on 6 January 2022, has also added to uncertainty in the US political landscape. These two events have exacerbated concerns about the country’s financial stability.
Notably, US debt has surged to over $31 trillion, and the International Monetary Fund (IMF) officially reported the nation’s debt-to-GDP ratio to be a worrying 122%, a level not seen since the aftermath of World War II, over 70 years ago. The last time the US debt was downgraded by another major credit rating agency was in 2011, that time by S&P. In that instance, the debt ceiling was also raised after a prolonged and difficult negotiation.
Following Fitch’s downgrade, financial markets experienced heightened volatility, impacting stocks and commodities. Surprisingly, the US dollar strengthened, reflecting increased demand for US bonds as investors sought safer assets amid the uncertainty.
The downgrade has drawn strong reactions from the Biden administration and Democratic officials. Treasury Secretary, Janet Yellen, vehemently disagreed with Fitch’s decision, calling it arbitrary and based on outdated data. The White House Press Secretary, Karine Jean-Pierre, echoed this sentiment, expressing strong disagreement with the downgrade and raising concerns about Fitch’s modeling. In response to the downgrade, Jean-Pierre pointed to Republican officials’ extremism – citing their support for default, undermining governance and democracy, and advocating for deficit-busting tax cuts for the wealthy and corporations – which she believes poses an even bigger threat to the economy. Senate Majority Leader, Chuck Schumer, also blamed House Republicans for the downgrade, holding them responsible for the negative consequences resulting from their reckless brinksmanship and flirtation with default.
What this downgrade does highlight, is that policymakers face a massive challenge of addressing the country’s debt situation and restoring stability to the economy.
A LOOK AT THE DATA
In the week ending 29 July, the number of Americans filing for unemployment benefits increased by 6,000 to 227,000, which aligns with market expectations and remains close to the previous five-month low. Continuing claims also rose by 21,000 to 1.7 million earlier in the week, in line with expectations and near the downwardly revised six-month low from mid-July. These slight increases highlight the persistent tightness in the US labour market, supporting the possibility that the US Federal Reserve (Fed) may extend its tightening cycle this year.
Euro area producer prices experienced a year-on-year decline of 3.4% in June 2023, the second consecutive drop, and the most substantial since June 2020. The decline was primarily driven by falling energy prices which were down by 16.5%. Prices also decreased for intermediate goods, while they rose at a slower pace for capital goods, durable consumer goods, and non-durable consumer goods. On a monthly basis, producer prices decreased by 0.4%, marking the sixth consecutive month of declines. Preliminary Consumer Price Index (CPI) figures revealed that headline inflation in the eurozone dropped to 5.3%, its lowest level since January 2022, while core inflation remained stable at 5.5%, significantly above the European Central Bank’s (ECB’s) 2% target. On the economic front, the eurozone’s economy returned to growth, expanding by a faster-than-expected 0.3% in the second quarter, surpassing forecasts of a 0.2% reading.
On Thursday, the Bank of England (BoE) raised its policy interest rate by 25 basis points to 5.25%, marking the fourteenth consecutive increase and reaching the highest level since 2008. The Monetary Policy Committee voted six to three in favour of the quarter-point hike, the difference in opinions was only on the size of the hike. While acknowledging the restrictive nature of the current monetary policy stance, due to the significant interest rate increases during the tightening cycle, policymakers emphasised their commitment to maintaining a sufficiently restrictive bank rate for a sustained period. The objective is to return inflation to the 2% target in the medium term. The central bank anticipates a significant decline in inflation to around 5% by the end of the year, surpassing its expectations from May. Furthermore, it projects a return to the 2% target by the second quarter of 2025.
In July, the Caixin China General Manufacturing PMI (Purchasing Managers’ Index) declined to 49.2 from 50.5 in June, marking its lowest reading in six months and falling short of market expectations of 50.3. This drop signals the first decrease in factory activity since April, with new orders shrinking following two months of growth. Foreign sales also contracted by their highest level since September 2022, and buying levels declined for the first time since January. Employment continued to decline for the fifth consecutive month, while backlogs of work remained stable. Delivery times worsened slightly, as some suppliers reduced their inventory level.
South Africa’s trade balance recorded a deficit of R3.54 billion in June, a significant decline from the downwardly revised R9.57 billion surplus in May, and well below the market’s anticipated R11.85 billion surplus. The drop in exports, by 8.6% to R167.6 billion, was primarily driven by reduced shipments of vehicles and transport equipment, down 28%, mineral products, which fell 13%, precious metals and stones, down 9%, and base metals, down 6%. However, there was a 4% increase in sales of vegetable products. On the other hand, imports decreased by 1.6% to R171.2 billion, mainly due to lower purchases of precious metals & stones, which fell by 32% and prepared foodstuff down 20%, while purchases of original equipment components rose by 4%. Considering the first half of the year, South Africa’s trade surplus significantly narrowed to R5.6 billion compared to R129.6 billion in the same period of 2022. Meanwhile, the ABSA PMI fell further to 47.3 from 47.6 in the previous month, indicating the sixth consecutive month of contraction in manufacturing activity and the steepest decline since July 2021. The drop in the business activity sub-index was significant, likely influenced by intensified power cuts and delays in receiving inputs due to transport disruptions on the N3 corridor. However, there was a positive note as the PMI price sub-index notably decreased in July. The data highlights ongoing challenges in the manufacturing sector, impacting overall business activity and output.
SURGING TREASURY YIELDS WEIGH ON EQUITIES
US stock futures were set for losses on Thursday as markets remained concerned about the combination of higher bond issuance and soaring borrowing costs, highlighted by Fitch’s decision to downgrade the US sovereign credit rating. The tech sector, including giants like PayPal and Qualcomm, is likely to experience volatile sessions due to their increased sensitivity to higher treasury yields after strong rallies in July. Investors are eagerly awaiting key corporate releases, including financial reports from Apple and Amazon after the market closes today.
On Thursday, the United Kingdom’s (UK’s) FTSE 100 index dropped by 0.6% to 7,510, but it recovered some of its earlier losses as investors digested the BoE’s latest rate decision. The markets now expect the rate peak to reach 5.68% in March 2024, slightly lower than the previous projection of 5.74%. Additionally, the index was influenced by fresh earnings reports. Telecoms company, BT Group, fell 4.3% due to trade of ex-dividend, while travel and tourism company, TUI, and medical tech company, Smith+Nephew, declined by 2.9% and 2.4%, respectively. Smith+Nephew reported a 5% smaller profit for the six months ending July 1. Conversely, financial services company, Admiral, saw a 4% rise in its share price, and luxury car brand, Rolls-Royce, added 3.8% after swinging back into profit in the first half of 2023.
In Europe, major bourses recovered slightly from earlier losses but remained in the red on Thursday afternoon. The DAX dropped by 0.8% to three-week lows at 15,890, while the pan-European STOXX 600 was down 0.6% to 458, its lowest level since mid-July. Traders continued to analyse fresh quarterly results and digest the BoE’s monetary policy decision. The tech sector was the worst performer, with Infineon shares plummeting nearly 9%, after the chipmaker forecast a decline in fourth-quarter revenue and margin. Airline, Lufthansa, also experienced a nearly 5% decline due to a free cash flow miss. On the positive side, Societe Generale gained 3.3% and ING edged 0.9% higher after both financial services companies reported upbeat earnings. AB InBev added almost 3.5% after the drink and brewing company exceeded expectations on earnings.
Japan’s Nikkei 225 Index dropped by 1.68% to close at 32,159, while the broader TOPIX Index tumbled 1.45% to 2,268. This marked the second consecutive session of losses, following Wall Street’s decline overnight, as Fitch’s recent US credit rating downgrade and a surge in treasury yields, negatively affected investor sentiment. Investors closely monitored the yen and Japan Government Bond yields after the Bank of Japan’s adjustments to its yield curve control policy at the previous week’s meeting. Technology stocks led the decline, with significant losses from companies like Advantest, Tokyo Electron and SoftBank Group.
On Thursday, the local JSE FTSE All Share Index extended losses for a third session, trading at over three-week lows of 76,100. Investors continued to assess the global economic outlook and closely monitored corporate earnings. South Africa’s private sector contracted for the fifth consecutive month in July, according to a fresh PMI survey. Among individual stocks, iron ore producer, Kumba, mining and renewable energy company, Exxaro, and telecoms company, Telkom, recorded the largest losses, while beverage manufacture, AB InBev’s shares shone with a 5% gain. On the earnings front, paper and packaging group, Mondi, reported a decrease in half-yearly revenues and underlying core profit, but managed to boost its interim dividend. Meanwhile, diversified wood-fiber company, Sappi, reported a decline in profit amid challenging economic conditions in its 2023 financial year. The market sentiment remained influenced by global economic dynamics and local economic indicators, with investors closely monitoring corporate performance in the ongoing earnings season.
RISK-OFF SENTIMENT WEIGHS ON COMMODITIES
The general risk-off sentiment in the market has put downward pressure on both the energy and metals sectors within the commodity sectors.
West Texas Intermediate Crude futures hovered around $80/barrel on Thursday, steadying after a 2% loss in the previous session. Fitch’s US credit rating downgrade contributed to risk-off sentiment in financial markets. Additionally, news of the Biden administration postponing plans to restock the US Strategic Petroleum Reserve amid high energy prices added pressure. On the positive side, oil prices were supported by Energy Information Administration data revealing a significant decline of about 17 million barrels in US crude inventories last week, the largest draw since 1980 and surpassing market expectations. Investors also awaited an Organisation of the Petroleum Exporting Countries meeting today, with expectations that Saudi Arabia would announce an extension of its one million barrels per day voluntary output cut through September.
On Thursday, gold remained below $1,940/ounce, staying close to its three-week lows amid pressure from a strong dollar. The US economy’s resilience in the face of higher interest rates has supported the Fed’s case for maintaining restrictive monetary policy. In addition to its sovereign downgrade of US debt, Fitch also predicted a mild recession in the fourth quarter of 2023 and the first quarter of 2024. The overall market sentiment for gold remains influenced by economic indicators and central bank policies.
Risk-off sentiment across financial markets negatively impacted industrial metals, with rising US Treasury yields and a stronger dollar exacerbating the downward pressure. London Metals Exchange copper extended declines for a third consecutive session, and nickel led the base metals in the decline. Chilean copper commission Cochilco reported the world’s leading copper producer, Codelco’s total copper production at 120.3 Kilotonnes (Kt) in June, their highest level for the year. However, cumulative output for the first half of the year fell by 12.7% year-on-year to 642Kt due to delays in structural projects. Codelco also reduced its annual production guidance to the lowest level in 25 years. On the other hand, BHP’s Escondida copper mine recorded gains of 8.7% year-on-year in June, with the biggest monthly output in at least 3.5 years, and year-to-date production increased by 5.5% year-on-year in the first half of the year. In response to volatility, the China Iron and Steel Association (CISA) has proposed the cancellation of night-time trading of metal futures, including iron ore and steel, to facilitate stable prices and trading for major metals.
DOLLAR BACK IN THE POUND SEATS
The US Dollar Index strengthened above 102.2 on Thursday, reaching four-week highs, as the US economy’s resilience in the face of higher interest rates outweighed concerns about the fiscal outlook due to the US credit rating downgrade. Risk aversion in the financial markets following the rating downgrade also boosted the dollar’s performance. An ADP National Employment Report indicating higher-than-expected US private payrolls in July reinforced the perception of a strong labour market, supporting the Fed’s stance to maintain restrictive monetary policy. Investors are closely monitoring upcoming economic data.
The euro saw a slight increase to $1.10/$ as investors analysed recent economic data and the monetary policy outlook. ECB President, Christine Lagarde, stated during an interview with media group, Le Figaro, that there could be a further interest rate hike or a possible pause in September. However, she emphasised that a pause, whether in September or later, would not necessarily be definitive. The ECB raised borrowing costs by 25 basis points in July, and many economists still anticipate another quarter-point rate increase by the end of the year.
The British pound declined towards the $1.26/$ level, reaching an over-one-month low. The drop came after the BoE raised its bank rate by 25 basis points, as widely expected by the financial markets. However, the sterling faced pressure as some market players still considered a sharper 50 basis points increase. UK inflation data confirmed that inflation remains higher compared to major European economies, adding to policymakers’ challenges in balancing the need to bring inflation down while dealing with the impacts of higher borrowing costs on the British economy. Plunging mortgage demand and a weakening manufacturing sector were observed as outcomes of the recent rate increase. Moreover, a stronger dollar also contributed to the pound’s decline.
The South African rand lost significant ground to trade at approximately R18.60/$, near three-month lows, primarily due to a stronger dollar and global risk-off sentiment following weak manufacturing activity in China and major European economies. Domestically, concerns remain about prolonged power outages and vandalism of public infrastructure.
The rand is trading at R18.66/$, R20.44/€ and R23.73/£.
Sources: Trading Economics, Wall Street Journal, Bloomberg and Refinitiv.