The US credit downgrade: What does it mean and should invests be worried? Fund Calibre MD Darius McDermott thinks not and that there are opportunities to be found.
Holiday season is in full swing (try pinning down a fund manager at this time of year!) and many of us will be flying out to balmy locations in the hope of rest and relaxation. The really lucky among us may even get that holy grail in air travel – a last minute seat upgrade.
But I don’t know anyone who would be pleased with a surprise downgrade on their flight. Yet that is exactly what the United States economy got at the start of August from rating agency Fitch, which lowered the US government’s top credit rating from AAA to AA+, a move that drew an angry response from the White House and surprised investors.
What does a credit downgrade mean?
In simple terms, a credit rating indicates a nation’s capacity to pay off its debt. The AAA rating is the highest you can get and it’s why US government bonds can be referred to as the “risk-free rate” – because it’s highly unlikely the US government will default on its debt. Every other asset is priced off this risk-free rate – meaning you look to see what extra compensation you will get for an investment over and above this to decide if it’s worth it.
In general, when an issuer of debt has its credit rating downgraded, that often means it has to pay a higher interest rate to compensate for the potentially higher risk of default it poses.
The US will survive the move of course, and the damage will be limited. But it does go to show what a tricky environment investors in the US are trying to navigate right now.
Have interest rates peaked?
One question on everyone’s lips is, after 11 interest rate increases that lifted the key lending rate 5.25 percentage points in 16 months, has the Federal Reserve (the US central bank) finished hiking?
Hugh Grieves, manager of the Premier Miton US Opportunities fund, reckons so. “Barring a nasty inflation surprise in the summer, the Fed is likely done,” he says.
“Monetary policy is now finally restrictive, and inflation is steadily heading in the right direction. From here, the Fed has said that it will be patient, not expecting inflation to finally fall to its 2% target until 2025. For investors that removes the risk of the Fed going too far and overtightening,” he said.
Some are expecting the US to slow progressively this year, and a mild recession to begin at the end of the year. But Hugh has been among those calling these fears overblown for some months.
He says: “Since the start of the year, I have been confident that the US will be able to dodge a recession due to several unexpected consequences from the pandemic which have confused economists’ traditional pre-Covid models.”
In summary his reasons for this optimism are: 1) the US consumer is sitting on lots of cash and little variable rate debt, helping to insulate them from higher borrowing costs; 2) there are around 5 million fewer US workers employed than pre-pandemic, making new job openings plentiful, companies fearful of laying off staff, and pushing up wages; 3) as a result workers/consumers are earning more, feeling confident, and so spending more and keeping the economy growing.
It is hard to argue with his logic, gloomy Fitch downgrade or no gloomy Fitch downgrade. What then are the current opportunities in the land of the free and the home of the brave?
Opportunities to be found
The Baillie Gifford American fund looks for 30 to 50 of the very best growth companies in the US with significant and underappreciated potential. These companies tend to be innovative and disruptive and are often founder-led. Fraser Thomson, client services director on the fund says this environment “should be a good one for the selective growth investor”.
“A tighter financing environment should drive greater differentiation between good and great companies. There is substantial scope for growth based on disruptive innovation,” he says.
AI is one example. Fraser admits some of the commentary might be hype, but he places AI in the context of the ongoing internet and cloud revolution.
He thinks we are at a “tipping point” from relatively narrow provision of this technology by a small-ish number of companies – seen best in current index concentration levels – to a broader deployment of these tools across all industries.
This is reflected in the fund. It has holdings in some of the more established providers of the infrastructure the fund manager believes “will underpin this next phase of disruptive growth” (including NVIDIA and Amazon), as well as holdings in much newer businesses challenging the status quo, such as the gamified education business Duolingo.
“The US remains the innovation capital of the world,” he says.
Opportunities for investors also abound in US smaller companies, which are at valuations that are already pricing in a lot of bad news.
“Smaller companies have not been so cheap relative to large caps since the technology bubble in 1999-2001,” says Rupert Rucker, investment director on the Schroder US Mid Cap fund.
Indeed, US smaller companies are trading at similar valuations to markets outside the US for the first time in years, Rupert points out, meaning you can still invest in the US economy without paying a premium.
For investors looking towards the US the economy looks steady, and on the surface the S&P 500 Index appears expensive compared to history. But this is down to the handful of very highly rated technology behemoths that dominate the index and skew the averages.
Outside of these, and especially further down the market cap spectrum, the US market is filled with great companies trading at more pedestrian valuations, and very much worth a look.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
