Weekly house view | No one is infallible

Last week, Fitch followed other ratings agencies by lowering the US’s credit rating from AAA to AA+. Fitch cited a deterioration in the fiscal outlook, a growing government debt burden and an “erosion of governance” as reasons for its decision. We have been here before. In August 2011, S&P cut the US’s top-notch rating on similar concerns, triggering a severe one-day sell-off of US equities and bonds. Even though the US debt mountain has grown in the past 12 years, the market reaction this time was much more subdued. This is in part because the US economy is, arguably, in better shape (economic growth had ground to a halt in H1 11). In this respect, it is worth mentioning the jump in nonfarm productivity growth to a three-year high in Q2 (+3.7% quarter on quarter after a decline in Q1), thus limiting the growth in unit labour costs to an annual 2.4% from around 7% a year ago. While this trend will need to be confirmed, the productivity figure adds further fuel to talk of a ‘soft landing’ for the US. It could also help US companies withstand recent margin pressure — as borne out by the fall in earnings per share for S&P 500 companies for the third consecutive quarter in Q2. This week, we will be watching closely the US consumer price index report for July.

While the short-term effect has been slight, Fitch’s justifications for the ratings downgrade are real issues with longer-term implications for US assets. The downgrade also set the tone for a sell-off in long-dated US Treasuries after the US stepped up its borrowing plans for the coming months. A weak-ish July nonfarm payrolls report helped to stop the rot, but the rally in shorter-dated bonds (as the market became more convinced that the Fed is at or close to the end of rate hiking) meant last week witnessed renewed steepening of the US yield curve. Given scope for further volatility in US bonds, we like derivatives that profit from yield curve steepening and protect capital. 

Central banks in some emerging markets have started to cut policy rates. A rate cut in Chile was followed by greater-than-expected easing last week by the Banco do Brasil. Having acted earlier and more decisively than their peers in advanced economies to head off inflation, a number of Latin American currencies figure highly among the top performers this year. Thanks to their discipline, central banks in some emerging countries are now in a position to cut rates, while falling inflation means their bonds and currencies continue to offer attractive real yields.