Jen's financial blog

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Fitch downgrades, market yawns

On August 1, Fitch Ratings downgraded its long-term U.S. Treasury rating from AAA to AA+, causing the U.S. to slip from the top-tier of fiscal strength to a lesser rank shared by Canada, Austria, Finland and New Zealand. The U.S. currently holds a slightly below perfect AA+ rating from S&P as well but retains its AAA designation from Moodys.

Fitch cited the United States’ mounting level of government debt—it expects the general government deficit to rise to 6.3% in 2023 from 3.7% in 2022—as well as a steady erosion of governance standards in its decision.  

Markets reacted, but not in a cataclysmic way. The Dow lost about 1%, the S&P 500 1.38% and the Nasdaq 2.17% the day after the announcement. Treasury yields barely budged.

The Fitch downgrade is a sign that recent debt ceiling shenanigans have consequences, even if the worst is averted, but still, the timing is a little weird. A deal to fund the government closed two months ago, and while budget negotiations loom for September, nothing has gotten measurably worse.

Indeed, Treasury Secretary Janet Yellen argued that Fitch’s assessment was based on outdated data that failed to reflect recent economic improvement. She stated, “At the end of the day, Fitch's decision does not change what all of us already know: that Treasury securities remain the world's pre-eminent safe and liquid asset, and that the American economy is fundamentally strong.”

Market observers largely dismissed Fitch’s movement. “Why now?” Queens College president and Allianz advisor Mohamed El-Erian asked Yahoo Finance. “When you look at the reason, you scratch your head as to the timing of this.”

Goldman Sachs acknowledged that the U.S. faces long-term governance and fiscal challenges but argued that there was nothing new here and that the downgrade wouldn’t likely affect financial markets.  Blackrock, likewise, said in a statement that, “We don’t see this action as a market driver and see no impact on U.S. Treasury market functioning.”

Fixed income titan PIMCO noted that growing deficits are a concern, but that the economy is showing surprising strength. “However, the firm looks for slowing in the second half of 2023—and expects choppier markets ahead. “Fitch’s downgrade is another reminder that risks related to deficit spending and debt sustainability, which tend to lie dormant, can arise and spark concerns. That creates the potential for market surprises and volatility, particularly given the diminished capacity for fiscal and monetary support.” So what’s ahead? Signs point in all directions. Debt levels are rising, but the economy is improving. Polarization persists, but the U.S. government is still basically functioning. These underlying weakness may, at some point, trigger volatility, but for now, markets are eerily unaffected. To quote Mad magazine, “What, me worry?

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The yield curve is upside down What does that mean for the economy?

In normal, boring, typical economies, investors demand higher yield when they lend out money for longer periods. There’s just more risk on a 30-year bond than a 1-year note. As a result, the typical yield curve slants up as it goes to the right. The longer the bond’s maturity, the more it pays in interest.

This is not a normal, boring, typical economy.

Since late spring, yields on short-term U.S. Treasuries have been higher than those on long-term Treasuries. For instance, right now, on the heels of a better than expected inflation report, the two-year U.S. Treasury yields 4.73%. The 10-year, by contrast, is yielding 3.86%, almost a full percentage point higher.

The last time the yield curve was this inverted was the early 1980s—on the brink of prolonged recession.

So what’s going on? The yield curve typically inverts when fixed income investors expect future economic conditions to be worse than they are now. If the economy deteriorates, the thinking goes, the Fed will have to reduce interest rates to promote growth. The market then prices long-term bonds to reflect this pessimistic scenario.

An inverted yield curve has preceded all five of the last recessions since 1980. Does that mean we’re headed into a slowdown?

Not so fast, say some economists. Nobel Prize winner Paul Krugman, for instance, says that an inverted curve reflects what market participants think about the economy—not necessarily what is happening. In an op-ed on Tuesday, he explained:

“But the meaning of an inverted yield curve is widely misunderstood. It doesn’t cause a recession. It is instead an implicit prediction about future Fed policy — namely, that the Fed will cut rates sharply in the future, presumably to fight a deepening recession. So the inverted yield curve wasn’t really independent evidence, just a market reflection of the same ‘recession is coming’ consensus you were hearing on cable TV.”

Krugman notes that everyone—from central bankers to Wall Street strategists—has been predicting a recession since the Fed started tightening in 2022, but that the slowdown has stubbornly refused to arrive. Does that mean it won’t ever? Probably not. But it may not be on the typical one-to-five timeline following an inverted curve.

The four most frightening words in finance are famously “It’s different this time,” but it may actually be a little different this time around. There are no signs that the curve is flipping to normal yet, or that we’re in even the earliest stages of recession. For now, investors can earn more on short-term notes than long ones—a boost for risk-averse, income oriented people.

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Car sales strong, but for how long?

Despite rising interest rates and record prices, American consumers have been buying cars—an unexpected bright spot in the U.S. economy. Through the first half of 2023, new vehicle sales are up 13% year on year. Though that’s still not up to pre-pandemic levels, it’s darn close—an auto manufacturing has turned into a major source of new jobs.  

The surge comes despite much higher costs to auto buyers. The average new vehicle price crested near $50,000 late in 2022 and has since drifted down a bit. However, prices remain extremely high by historical levels at $48,528 on average in May.

Financing has gotten pricier, too. At the start of the pandemic, a four-year auto loan carried an average interest rate of between 5.00% and 5.50%. By early 2023, that rate had bumped up to 7.50%.

Those higher costs haven’t stopped upper income Americans from purchasing vehicles, but they’re starting to bite at the lower end of the economic scale. New loan originations hit a four-year low in the first quarter of 2023, as banks tightened lending standards, and delinquencies have headed up, especially in the sub-prime sector of the market.  

Young people, especially, have felt the strain. A report by the World Economic Forum found that auto loans to Americans under 40 have grown in average size by 41% since 2019 and now average $24,000. Defaults among Gen Z and Millennial buyers is up sharply, too. In 2022, these younger cohorts fell more than 90 days behind on some $20 billion in auto debt. That strain will likely increase when student loan repayments begin again this fall.

All that is starting to put pressure on auto lending. In May, for the first time in three years, non-revolving loans — that is, primarily auto and student loans — dropped in volume. That suggests that the strong, post-pandemic demand for automobiles may be finally running out of gas.

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Junk bonds are behaving very strangely

Money has been flooding into bonds all year, as the market looks for a recession that stubbornly refuses to happen. Through May nearly $113 billion net flowed into taxable bond funds according to Morningstar, with market-leading institutions including JPMorgan, Pimco, Charles Schwab, Fidelity Investments, and Amundi, declaring that “bonds are back” after 2022’s historic 16% loss.

High yield bonds, however, should be a different story. Non-investment grade debt typically does well in a strengthening economy, as even poorly capitalized companies benefit from widespread growth. If the market really does anticipate slowing growth and lower rates, junk should be under pressure. It’s not.

Indeed spreads to Treasuries have tightened measurably this year, with non-investment grades yielding only about 4.15% more than the risk-free benchmark. That differential has shrunk by nearly half since a peak in late March when junk bonds yielded 9.2%, compared to 0.7% for Treasuries.

Do high yield investors just have a more positive take on the economy than others? Seems unlikely. And indeed, the issue may be a simple case of supply and demand. Issuance of less-than-investment grade debt is down dramatically, and that supports prices.

High yield issuance peaked in 2020, at $450 billion, and remained near record levels in 2021 ($410 billion), as below-investment grade borrowers rushed to lock in historically low rates. That has allowed many high yield issuers to sit out current, less receptive conditions and wait for potentially lower rates and cheaper financing to come. Issuers that are seeking financing are taking on shorter-term obligations.  Indeed, the Wall Street Journal reports that junk debt’s average maturity has shrunk to 6.1 years, down from a historic norm of 7.4 years.

Issuers that can’t wait for financing are also using another strategy to reduce costs—offering secured loans that provide investors with additional protection in case of default. So far in 2023, around 62% of total non-investment grade issuance has been secured, nearly double the levels in 2022 and 2021.

Fewer junk bonds, better investor terms and a recession that remains elusive. It’s all supporting the non-investment grade market for now. But for how long?

[jensfinancialblog]

Is low volatility a good sign for stocks?

A note in Barron’s this morning highlighted an interesting fact. While all the broad stock market indices were slipping in reaction to the Fed’s announcement (short version: no rate hikes now but probably later), the VIX Index, which measures stock market volatility, was also down.

That’s unusual. More often falling stock prices come in tandem with increasing volatility.  Economists theorize that when volatility increases, investors demand more compensation for the additional risk they are taking on. That means that they need to buy a stock’s future income stream—which reflects future company profits—at a lower price. Hence stock prices and volatility measures are negatively correlated. When one goes up, the other one falls.

Historically the highest peaks in stock market volatility have accompanied precipitous market drops. Black Monday in October 1987, the East Asian Currency crisis in 1997 and the collapse of the dot.com boom in 2000 all saw elevated volatility readings (see chart below).

Source: Federal Reserve Bank of St. Louis, 2002.

So when stock prices and volatility fall at the same time, that’s interesting but also possibly transitory.

Consider that stock prices have only been falling for a few days now (and both the S&P 500 and the Nasdaq 100 eked out a small gain today), while longer-term the trend has been mostly upwards. The S&P 500, for instance has been on the rise, more or less, since March 10, 2023. Even after a couple of sessions of pullback, it’s risen 13% from that trough.

Interestingly, the VIX peaked at 26.52 just about the same time, on March 13, and has been on a downtrend ever since. So for most of early 2023, the market performance/VIX relationship has worked exactly as expected—stock prices have risen and volatility has dropped.

Barron’s noted that the unusual synchronicity probably indicated that investors weren’t too worried about the recent market decline, a good indicator that the current downturn might be quick and relatively painless.

However, lower volatility has its own downside. Without sharp market movements, it’s harder to make money with active bets—and hedge funds, trading desks and active managers all see lower profits and revenues. A calm market sinks fewer ships, but it becalms the faster ones. That’s good for long-term investors, but not so hot for the financial industry.  

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What you should know about anti-ESG funds

Like pollution? Global warming?

You should know about anti-ESG funds

The backlash to ESG is well underway with ten states—including Arkansas, Florida, Kansas, Kentucky, Indiana, Montana, North Dakota, Tennessee, Utah and West Virginia—all enacting legislation that, one way or another, prohibits incorporating environment, social or governance metrics into the management of their pension funds.  

Blackrock, a leader in ESG investment, is facing down the possibility of boycotts in conservative controlled states—and has seen some $4 billion in pension mandates taken away  Florida, Texas, Louisiana and South Carolina.

It doesn’t help that energy shortages caused in part by the Russia-Ukraine war have pushed fossil fuel stocks—often excluded or underweighted in ESG portfolios—skyward. ESG-focused investors aligned with carbon reduction would have missed out on massive gains in 2022. Exxon was up 85%, Chevron by 57% and Shell by 51%.

Red state pension plans are all in on the anti-ESG trend, but individual investors have options, too. Morningstar recently categorized five types of anti-ESG funds available on the retail market. These include:

Anti-ESG funds, which invest in companies that are excluded by ESG focused analysis

Political funds, which align their portfolios with conservative values

Renouncers, or funds that used to be ESG but now are de-emphasizing that category for marketing purposes

Vice funds, which invest in tobacco, alcohol, gambling and firearms, all traditionally excluded from socially responsible portfolios

Voter funds, which invest passively but vote against pro-ESG proxy measures.

Anti-ESG funds inflows peaked in the third quarter of 2022, according to Morningstar, gaining $377 million in assets. Since then growth has slowed by about half, gaining $183 million in the first quarter of 2023. The category remains relatively small at $2.1 billion in assets.  

These funds are heavily concentrated in fossil fuel stocks, with an average weighting of 45% according to Morningstar, so performance is influenced by volatile energy prices.  Also, most of them are new. Performance records are scanty, so far, with most entries lacking even a 1-year track record, let alone three or five. Still CitiWire reported that Q4 2022 and Q1 2023, the average anti-ESG fund delivered a 17% return, which was two percentage points higher than the Morningstar US Market index.  

So far, there’s not enough evidence to evaluate whether ESG or anti-ESG vehicles perform best over time, but the market will sort it out. Until then, you can invest for a better world or a worse one. Your money, your choice.