The biggest news of last week arrived on May 16, with the announcement that Moody’s had downgraded the US’s credit rating, citing the failure of successive administrations and Congress to “agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs.”
Although longer-term government bond yields rose slightly on the news, this is unlikely to have a significant impact on demand for US bonds in the short term as investors lack realistic alternatives of sufficient size and liquidity to replace Treasuries. Morningstar DBRS is the last of the big four credit ratings agents to retain the US’s AAA rating. You can read why here.
US Market Valuations
The Morningstar US Market Index rose 5.3% last week led by consumer cyclical, technology and communications services sectors. The Magnificent Seven stocks were the key drivers of these returns as investors regained confidence in the future of international trade following limited tariff agreements with the UK and China.
Following this wave of optimism the US market is now 1.7% higher than at the start of the year and is priced in line with Morningstar analysts’ assessment of its fair value, suggesting that new investors can expect more “normal” returns from this starting point. However, the market movements of the last few weeks show the importance of a realistic fair value estimate in assessing the attractiveness of assets. These fair estimates are especially relevant as we draw to the end of the reporting season as they reflect recent data.
When we look more deeply at the market, valuation disparities remain with US large-cap growth stocks now priced 8.2% above their fair value, and small-value companies are trading at a 14.4% discount. This suggests opportunities for patient investors.
Persistent ‘Uncertainty’ Evident in US Earnings Calls
Despite the optimistic mood of investors, the impact of rapid changes in trade policy continues to be a dominant topic in America’s boardrooms. This was highlighted by FactSet which calculated that “uncertainty” was cited in 381 of the conference calls following results from the US’s largest companies. This is the highest number since the first quarter of 2020 when the world was wrestling with the outbreak of covid-19.
Uncertainty also remains uppermost in the minds of economists. While the economic data released last week was broadly in line with expectations, the spread of forecasts for economic growth for the second quarter of the year remains very wide, according to the Atlanta Federal Reserve Bank. The most optimistic forecasts suggest annualized growth of 3%, while the most pessimistic foresee a decline of 1%. The Atlanta Fed’s model is near the top end of this range at 2.4%, contributing to the optimistic sentiment among investors.
Where Next for Interest Rates?
Higher expected growth coupled with little evidence of accelerating inflation has likely fueled the decline in expectations of an interest-rate cut. According to CME’s Fed Watch, investors are now assigning a 92% probability of rates remaining on hold at the June 18 meeting, up from 83% at the start of last week and 34% a month ago.
With a paucity of economic data and fewer company results this week, the numerous planned comments of Federal Reserve officials are likely to take on extra importance for market commentators, who will be scrutinizing their utterances for indications of future interest rate decisions. However, given the FOMC’s patchy record of predicting their own behavior, a forensic assessment of these comments is unlikely to yield useful information for investors.
Investors Should Remain Diversified
It is more important than ever for investors to invest in a way that enables you to navigate a broad range of potential outcomes, rather than focusing too closely on a single outcome that may, or may not be realized. In reality this means ensuring your investments remain diversified. Morningstar has recently published a guide to diversification which you can access here.
This rapid change in the economic and market environment can easily overwhelm investors seeking to make good investment choices. To help investors navigate through ‘choice overload’, check out this article by Morningstar behavioral scientist, Samantha Lamas.