Uncle Sam Gets Downgraded

New data out last week showed the eurozone economy returned to growth in the second quarter. Core inflation in the bloc, meanwhile, defied expectations for a drop and remained elevated last month. Elsewhere, new data out last week showed activity in China’s manufacturing sector contracted in July, offering fresh evidence that the world’s second-biggest economy is losing momentum. But let’s have a moment of silence for the world’s biggest economy, the US, which just got stripped of its top-tier sovereign debt rating by Fitch. Across the pond, the Bank of England raised interest rates by a quarter of a percentage point last Thursday, taking rates to their highest level since 2008. In the equity world, long-short hedge funds are derisking their books amid this year’s convoluted markets. Finally, Treasuries are exhibiting their worst performance as a stock hedge since the 1990s. Find out more in this week’s review.

Macro

After sinking into a mild technical recession in March, the eurozone economy returned to growth in the second quarter, with GDP in the bloc expanding by 0.3% from the previous three months. That was slightly ahead of the 0.2% expected by economists. The growth was buoyed by a 3.3% surge in Irish GDP over the period, contributing about 0.1 percentage points to the bloc’s overall second-quarter growth. However, Germany – Europe’s biggest economy – is struggling: despite barely recovering from a six-month recession over the winter, the country's economic output remained stagnant in the second quarter.

A separate release last week showed consumer prices in the eurozone rose 5.3% from a year ago in July – in line with economist estimates. But in a sign of lingering underlying price pressures, core inflation, which excludes volatile costs like food and energy, overshot estimates to stay at 5.5%, surpassing the headline gauge for the first time since 2021. What’s more, services inflation rose to a record high of 5.6%. Taken together, the better-than-expected GDP report and worst-than-expected inflation readings support the European Central Bank’s argument to continue raising interest rates over the rest of the year.

Elsewhere, new data out last week showed activity in China’s manufacturing sector contracted in July, offering fresh evidence that the country’s economic momentum is losing steam. The Caixin manufacturing purchasing managers index (PMI), a measure of manufacturing activity in Asia’s biggest economy, declined to a six-month low of 49.2 in July from 50.5 in June, and below the key 50 level that marks a contraction. Manufacturers reported muted foreign demand as a key factor weighing on total sales, with new export orders down noticeably in July.

The poor data comes alongside a raft of pledges from the government in recent days to bolster the economy, including boosting credit to private companies as well as lowering mortgage rates and down payment ratios to help revive the struggling property market. However, economists have cautioned that the government has stopped short of announcing large-scale stimulus and that some of the measures, like those intended to boost confidence among private businesses and consumers, will take time to have an effect on growth.

Elsewhere, the US was stripped of its top-tier sovereign debt rating last week by Fitch Ratings, which criticized the country’s ballooning fiscal deficit and an “erosion of governance” that’s led to repeated clashes over the debt ceiling in the past two decades. The cut takes the US’s credit rating down one level from AAA to AA+, and comes two months after political confrontations nearly pushed the world's biggest economy towards a sovereign default. Fitch’s decision echoes a move made more than a decade ago by S&P Global Ratings.

See, tax cuts and fresh spending programs, along with several economic upheavals, have inflated the government's budget deficit, which is expected to hit $1.39 trillion for the first nine months of the current fiscal year – an increase of approximately 170% compared to the same time last year. That rise is partly due to rising interest rates and the US’s rapidly swelling debt pile, which Fitch forecasts to reach 118% of GDP by 2025 (over 2.5x higher than AAA-rated countries’ median of 39%). The rating agency projects the debt-to-GDP ratio to rise even further in the longer term, increasing the US’s vulnerability to future economic shocks.

Finally, across the pond, the Bank of England (BoE) raised interest rates by a quarter of a percentage point last Thursday, taking rates to 5.25% – their highest level since 2008. Policymakers were split three ways, with six favoring a quarter-point hike, two voting for a half-point increase, and one calling for no change. The BoE had previously raised rates by half a percentage point at its last meeting a couple of months ago, and traders saw a 33% chance of a similar move this time around too. But a bigger-than-expected fall in the UK’s inflation rate in June probably gave policymakers the confidence they needed to opt for a smaller move.

Traders now see interest rates peaking slightly below 5.75%, implying roughly two more quarter-point hikes to conclude the current tightening cycle. But that might prove to be too conservative. In fact, the BoE’s updated forecasts suggest that even if interest rates rise in line with market expectations, it will still take until mid-2025 for inflation to fall from today’s 7.9% to the central bank’s 2% target. That’s arguably too long for the BoE’s liking. And for traders hoping the bank will cut interest rates soon after they peak, the central bank offered a pretty strong rebuttal, saying that rates will remain “sufficiently restrictive for sufficiently long” to bring inflation back to target.

Stocks

In 2023's convoluted markets, stock-picking hedge funds are starting to see the potential risks outweigh the potential gains – and they’re retreating accordingly. According to JPMorgan, long-short hedge funds significantly slashed positions on both sides of their book last week, in a process known as de-grossing. Morgan Stanley’s hedge fund clients demonstrated a similar pattern of risk reduction, with their de-grossing activity last week being the largest so far this year. Meanwhile, Goldman Sachs's clients trimmed positions in 12 of the last 14 trading sessions.

See, contrary to many forecasters' predictions, the S&P 500 has climbed in all but two months since October, rising 28% over that stretch. While the equity rally may be beneficial for those holding long positions in the market, it's presented challenges for hedge funds’ short positions, leading to widespread capitulation in the form of de-grossing. This trend is evident in the graph below, which shows a price index of Goldman Sachs’s basket of most-shorted stocks surging last quarter (red line).

However, as investors chase the rally, some wonder whether the sentiment pendulum has swung too far in the opposite direction. After all, retail investors are reviving their fascination for meme stocks, while options traders are rushing to buy call options to capitalize on potential gains. And according to the latest poll by the National Association of Active Investment Managers, equity exposure just increased to its highest level since November 2021. Nonetheless, few investors seem concerned enough to hedge their bets, with the cost of buying protection against dips in the S&P 500 in the options market hitting its lowest level since at least 2008.

Bonds

Lately, Treasuries are exhibiting their worst performance as a stock hedge since the 1990s. Traditionally, Treasuries tend to rally when stocks tumble, serving as a hedge and contributing to the success of the 60/40 strategy (made of up 60% stocks and 40% bonds). However, the one-month correlation between the Bloomberg US Treasury Total Return Index and the S&P 500 rose to 0.82 last week, indicating that bonds and stocks are moving almost in sync. Between 2000 and 2021, the correlation between the two asset classes averaged -0.3. This change in relationship started last year as the Fed raised rates to combat inflation, impacting both fixed-income and equity markets and making it harder for investors to achieve proper diversification in their portfolios.

This week

• Monday: Sentix eurozone economic index (August). Earnings: Palantir Technologies.
• Tuesday: China trade balance (July), Japan household spending (June). Earnings: AMC Entertainment, Rivian Automotive.
• Wednesday: China inflation (July). Earnings: Disney.
• Thursday: US inflation (July). Earnings: Novo Nordisk.
• Friday: UK GDP (Q2).