When doing your research to invest, the question always is, what information is relevant, and what information can be considered noise. However, before we head into today’s publication, we want to give you a quick status update on our visit to Tennessee. Last month we were in Memphis, participating in the Freedom Fest. Next to having our booth, where we gave away a lot of Swiss chocolate, we held a presentation titled “Crossing the Atlantic to Financial Freedom.” Make sure to check it out to hear what we have to say about Swiss banking for privacy, diversification, and asset protection.
Credit Rating AA+ by Fitch
Now, without further ado, let’s start with today’s topic. On August 1st, the credit rating agency Fitch announced that they downgraded the credit rating from the U.S. from AAA (which is the best possible rating) to AA+ (which is the second highest rating). Among others, the reasoning behind this step is the suspended debt ceiling and the high debt-to-GDP ratio, which we addressed in previous publications. While the announcement itself is already worrying, it is not comparable to the reactions that followed and were packed with unreasonableness and arrogance. By saying that, one or the other could guess where the title of today’s Swiss View came from. It was no one less than Jamie Dimon, CEO of JPMorgan. He stated that the downgrade is “ridiculous” but that “it doesn’t really matter” since the market, not rating agencies, determines borrowing costs. While this is not wrong per se, it is essential to understand that markets, to a certain extent, base their decisions on rating agencies. Otherwise, rating agencies like Fitch, S&P, or Moody’s would have never become that influential. The funny part about that is that back during the U.S. mortgage crisis, the same rating agencies were criticized that they adapted their ratings towards the wishes of the institutions they rated. Now, the U.S. is officially trying to influence this decision. However, it is not only Jamie Dimon who felt frustrated. U.S. Secretary Janet Yellen commented on this decision as “surprising” and “entirely unwarranted.” From an outside perspective, it is surprising that such influential and educated people do not recognize (or admit) that the U.S. financial household is in trouble.
Furthermore, Fitch’s downgrade decision is not the only event threatening the hegemony of the U.S. and the U.S. dollar. Within the past years, different developments are leading toward a multipolar world. You might remember when 2018, the U.S. announced its withdrawal from the Iran nuclear deal and reimposed sanctions. This led to an Iran–China 25-year cooperation program in 2021, where China promised Iran investments of USD 400 billion in exchange for access to cheap oil. Also, the strong ties between Saudi Arabia and the U.S. have lost power in recent years, finding its height when Saudi Arabia agreed to cut oil production last year after meeting with U.S. President Biden, who asked them not to do so.
On top of that, with many other countries, Iran and Saudi Arabia are eager to join the BRICS states. In the meantime, everyone might have heard about the BRICS and their efforts to disconnect from the U.S. and its currency—accordingly, the BRICS plan to introduce a currency backed by gold and other metals with intrinsic value. After starting with a rather specific issue this time, let’s dive into the equity markets.
When Normalcy Returns
Equity markets have found a halt. The rally we observed in the first half of the year was unprecedented. And honestly, it is not what we expected. However, as we already determined in our last publication, the rally was driven by a few stocks rather than by an expanding economy. On top of that, the rally was tied to the hype of artificial intelligence. Well, that’s water under the bridge.
The question is what to expect from the rest of the year. Is the halt in equity prices the start of a more volatile environment leading back to price levels seen last October? We believe so. The reason is that corporate profits will sink further. That leads to lower valuations, meaning lower stock prices. Financing costs are still on the rise. With increased interest rates, sticky core inflation, decreasing corporate profits, and weak consumer confidence, chances are that banks will become even more restrictive in giving out loans. This is not only an issue in the U.S. and Europe. Last week it was announced that Chinese banks’ lending plummeted to Rmb 345.9bn (USD 47.8bn) instead of the expected Rmb 800 bn. This is the lowest figure since 2009, even though the Chinese central bank lowered interest rates in June to boost consumer spending.
On top of that, China has entered deflation while many other countries (especially in the Western hemisphere) still struggle with inflation. The main concern is that Chinese people postpone consumption to get the products tomorrow at a lower price.
This scenario can potentially extend to Europe and the U.S., although we do not expect that to happen soon. We expect inflation to stay Western central banks' main obstacle this year. Due to the lack of products which leads to the inflationary environment, we find ourselves in a scenario where companies are piled up with inventories. However, consumer confidence is still depressed, leading to a situation where too much supply meets too little demand. Should sellers come to the conclusion that this is an issue, they will try to get rid of their inventory quickly. As more sellers join the party, an economy could enter a deflationary environment. And as you probably guessed, deflation can intensify the pressure on corporate profits.
The consequence of a deflationary scenario is the same as in an inflationary one. Focus on companies that have pricing power. I.e., people will stay loyal to their products even if they do not match the lowering prices of their competitors.
Top of Interest Rates
We expect interest rates to be close to their height. There may be one or two further interest rate hikes, which will be around 0.25% each instead of 0.5%. Accordingly, fixed-income investments with longer maturities become more attractive again. The reason is that interest rates greatly influence the required rate of return on bonds. Given that the interest rate in the U.S. is 5.25%, you want to have a higher return from institutions that are less secure than your government. Although the U.S. has issues with its financial household and its credit rating was reduced by Fitch, the probability that the U.S. will fail on its debt payments is still marginal.
As we advance, we expect that central banks will keep interest rates near the current levels for some time before lowering them again. Central banks are already reducing interest rates in some parts of the world, particularly in Asia (e.g., China and Vietnam).
The outlook of interest rates not rising much further allows you to lock in a good yield on your fixed-income investment. Since interest rates will stay higher for some time, there are opportunities to take on short-term and mid-term bonds without carrying too much interest rate risk. I.e., you will still be able to get a decent return for bonds you buy in about two years. Accordingly, a combination of short and mid-term bonds makes the most sense to us in the current environment.
While we consider short-term bonds as bonds with a maturity of about two years, mid-term bonds represent maturities of about three to seven years.
What do Central Banks see?
Central bankers kind of live in their own world and have much more power than regular investors. While there is upheaval not only in geopolitics there is also a lot going on in the forex market. Central banks are aware of that and show how they prepare. A significant turn is the tremendous amount of gold purchased by central banks over the last two years. While Turkey’s central banks sold some gold in the first half of the year, expectations are that this is not motivated by a changed perspective but rather by a response to local market dynamics.
In July, we observed another increase in the gold price followed by another drop to levels we saw at the end of June. The same is true for Silver.
We stay the course and believe that precious metals are a good investment. They serve as a hedge in uncertain times. Even though the U.S. dollar could regain some strength during the next couple of months due to insecurity, we believe that precious metals will outperform equities in the year's remaining four and a half months. However, once markets drop and some panic comes into play, don't be surprised if precious metals start falling before regaining their strength and proving themselves as a haven. We have seen that behavior over and over. Investors who speculated for the wrong outcome need liquidity and, therefore, must sell their assets that still hold value to cover their margin calls. It is as simple as that.
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