Weekly Investment Update (08/04/2023)

Labor Market Remains Strong With Emerging Signs of Cooling

Although signs of labor market softening persist, July’s jobs report largely highlighted a resilient labor market. The resilience is underpinned by an unemployment rate that fell to 3.5% from 3.6% in June, a participation rate that held steady at 62.6%, and a household survey that showed a healthy increase in household employment. Initial jobless claims have ticked down with layoffs decreasing in recent weeks, a sign that companies may be reluctant to reduce headcount despite a slower growth environment. Notably, wage growth accelerated more than expected, but the rise in productivity could offset further inflationary pressures.

Despite the overall strong report, there are many signs of labor market conditions easing. Non-farm payrolls increased by 187K in July, marking the lowest increase since December 2020. The below-expectations July payroll number was paired with negative revisions of 49K jobs over the last two months. Service-oriented areas of employment remain strong, while cyclical areas showed weakness. In recent months, we have witnessed a notable deceleration in the pace of job growth; over the last three months, the average job gain was 218K, a slowdown from the average of 300K over the prior nine months. Additionally, signs of weakness emerged in two important leading indicators of labor market conditions; the ongoing contraction in temporary hires and reduction in hours worked could be indications that companies are scaling back hours and slowing hiring rather than laying off employees.

Overall, July’s jobs report points to a cooling labor market with continued wage pressure. So far, the Fed has been able to effectively slow the pace of job growth without materially weakening the labor market. Still, we expect further loosening in the labor market as the lagged and variable impacts of elevated interest rates permeate the economy, helping to better balance labor supply and demand. There are no immediate policy implications as an additional jobs report and two inflation reports will be released before the next FOMC meeting, and we expect the Fed to remain in a data-dependent mode.

Fitch Downgrade and Larger-Than-Expected Treasury Issuance Bring U.S. Deficit in Focus

Credit rating agency Fitch surprised investors this week by lowering its U.S. sovereign credit rating from AAA to AA+. While Moody’s still holds its AAA rating for U.S. sovereign debt, S&P has maintained an AA+ rating since its 2011 downgrade. Fitch used much of the same rationale as S&P did in 2011, noting lowered confidence in U.S. fiscal governance after a tenuous debt ceiling debate as well as a worsening outlook for the U.S. deficit with rising borrowing needs. While the median AAA-rated country’s sovereign debt-to-GDP ratio is 39%, the U.S. public debt-to-GDP ratio is set to exceed its World War II peak of 106% this year. It is important to note that we are unlikely to see meaningful forced selling due to the Fitch downgrade as most investor mandates specifically reference U.S. government debt for asset allocation purposes.

While the debt downgrade grabbed headlines this week, perhaps even more notable was the U.S. Treasury announcement that third-quarter U.S. Treasury issuance would be $1.0 trillion, $274 billion larger than the prior projection. Even though the U.S. interest rate burden has grown as rates have risen over the past year, the U.S. remains able to issue debt to fund its spending needs with ample global demand for U.S. Treasuries.

U.S. 10-Year Treasury yields moved up toward the top of this past decade’s range, reaching 4.17% on Thursday. While the debt downgrade and larger-than-expected Treasury issuance have been credited for some of the yield move, the rise in yields also likely reflects an improving economic landscape and the Bank of Japan’s adjustment to its yield curve control policy, which signals more flexibility potentially going forward.

Looking ahead, we expect the largest driver of yields to continue to be the outlook for inflation and economic growth. With the Fed nearing the end of its rate hiking cycle and global central bank balance sheets poised to shrink in the future, the market will soon need to absorb a large supply of sovereign paper. We will be closely monitoring dealers’ ability to absorb supply and for any signs that market functioning is affected as the Fed may adjust its quantitative tightening plans as a result. Overall, with inflation and growth slowing, portfolio managers have favored positioning that is longer duration than respective benchmarks for the majority of this year.

Emerging Market Central Banks Begin to Cut Interest Rates, Diverging From Their Developed Market Counterparts

Emerging market central banks led the global interest rate hiking cycle to combat higher inflationary pressures but are now among the first to start cutting rates. The central banks of Chile and Brazil cut rates more aggressively than expected this week, reducing rates by 100 basis points (bps) and 50 bps compared to consensus expectations for 75 bps and 25 bps, respectively. Inflation in Chile and Brazil has declined from the double-digit readings seen last year, though growth in the countries has slowed given still-elevated interest rates. With inflation moderating, emerging market central bank policymakers are starting to shift their focus from combating inflationary pressures toward supporting growth. As emerging market central banks seek to balance supporting growth and fighting inflation, monetary policy remains contractionary given the high interest rate levels in these countries (for example, Brazil’s interest rate is 13.25% and Chile’s is 10.25%).

Developed market central banks are at different stages of their monetary cycles compared to emerging market central banks. While some emerging market central banks have begun the process of cutting interest rates, most developed market central banks have yet to announce a formal conclusion to their hiking cycles. The Federal Reserve and European Central Bank (ECB) both delivered widely expected rate hikes last week, with both noting that they will be following a data-dependent approach in deciding whether they will hike at their September meetings.

Despite the divergence in monetary policy between developed and emerging markets, the global hiking cycle appears to be near its conclusion, which has allowed for interest rate volatility to subside and should continue to support equity and bond markets going forward. Bessemer’s All Equity Model Portfolio is underweight emerging markets relative to the benchmark as Bessemer’s portfolio managers continue to find superior investment opportunities in the U.S. relative to other global developed and emerging markets.