No Time for Complacency

Doug Walters, CFA

A downgrade of US credit puts it in lower standing than tech giant Microsoft. Now is an excellent opportunity for a gut check on complacency.

Contributed by Doug Walters, Max Berkovich, David Lemire, Eh Ka Paw

Microsoft has better credit than the United States of America (at least according to two rating agencies). We discuss the Fitch downgrade in our Headline of the Week. So how should investors approach this seemingly upside-down credit world?

It is easy to take for granted the US stock market’s strength over the past decade and a half and assume it will continue. But market dominance can change quickly, and the credit downgrade provides a reminder of that fragility. This week’s market reaction was pretty sanguine, but sentiment can turn quickly. Investors should not be complacent.

The US stock market strength is ironically (and not coincidentally) driven by AAA-rated Microsoft and other mega-cap technology giants like Apple, Alphabet, and Amazon. They have become such an unstoppable market force it would be easy to assume they can continue to drive portfolios indefinitely. But their shares price in huge growth expectations, and the bigger they get, the harder it is to find growth.

So, investors should prepare, and a good start is diversification. Avoid too much “home bias” by allocating a portion of your portfolio to developed international and emerging markets. Avoid too much exposure to expensive mega-cap tech. We do that by targeting funds that are not market-cap-weighted and building a healthy allocation to small-cap stocks. Diversification!

As we often remind our readers, we are not making predictions. We have no crystal ball and are not reading impending doom in the tea leaves. Instead, we are focused on what we know today and preparing our portfolios for the inevitable uncertainty of tomorrow.

Headline of the Week

One Notch Below Impeccable

Rating agency Fitch downgraded US credit one notch from its highest rating of AAA to AA+. The move follows similar action by S&P back in 2011.

Despite being separated by over a decade, the justifications for the two downgrades were similar, with both coming after a contentious debt ceiling debate. Fitch noted the US’s growing debt burden combined with a divided political environment that appears incapable of coming together to tackle the big economic challenges of the day.

The limited financial market fallout this week put the move in perspective. The US debt and political challenges are a well-understood, slow-motion approaching collision. For now, markets take comfort from the fact that the US dollar remains the world’s reserve currency, and there is still time to avoid the worst of the impact.

The Week Ahead

Inflation reports, a Gross Domestic Product from the United Kingdom, and only a handful of marquee earnings reports are all we have next week, but China may catch some attention in a slow news week.

To the Core

The Consumer Price (CPI) and Producer Price (PPI) Indices are out next week, first looking at July inflation.

Headline consumer inflation should show further progress since last summer’s energy-driven inflation will roll off. However, the core number, which excludes the volatile food and energy numbers, is the focus.
While expected to moderate, the core CPI is still pegged to just shy of 5% year over year.
The monthly inflation is expected to be 0.2% for both PPI and CPI, and that would keep inflation on pace to work its way down to a 2% annual figure.
If there are no negative surprises on inflation, coupled with a market-driven increase in interest rates this past week, the Federal Reserve may not need to hike in September.

The King Maker

Gross Domestic Product in the United Kingdom is expected to remain in expansion mode.

Royal events tended to impact the British economy negatively, but the King’s coronation did not detract from the economy.
If the economy stays in the expansion column, it is unlikely that the Bank of England will pass on a rate hike in September.

Trickle

Earnings season is coming down to a trickle, with only a few major names on the calendar.

Disney (DIS) and Eli Lilly (LLY) are the highlights.

Looking to the East

The Bank of Japan’s summary of opinions, kind of like minutes of the meeting, and inflation and export data from China may get more airtime than usual.

The Bank of Japan (BOJ) executed a back door tweak to its yield curve control program at its last meeting, so color on why will be of interest to bond and currency markets.
Also, the BOJ increased its inflation expectation to above the 2% target, which left the market uneasy about what was up to now mild inflation in Japan.
Previous trade balance reports from China indicated exports were weak. Experts will be watching to see if geopolitical tension continues to impact China’s exports.
So far, Chinese inflation has been a non-issue, and with easing price pressure on commodities, it is expected to remain as such. But it is still worth watching for any unwanted surprises.

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