Credit ratings agency Fitch stopped market bulls’ push for a fourth consecutive winning week for the Dow Jones Industrial Average. Fitch is one of the top three credit rating agencies internationally along with Moody’s and Standard and Poor’s. On Tuesday, the firm downgraded the U.S.’s credit rating from AAA to AA+. Fitch cited “expected fiscal deterioration over the next three years” along with growing debt and political dysfunction as reasons for the downgrade. Markets seemed to be caught flatfooted by the move even though investors have been fully aware for an extended period of time of the constant political partisanship playing out on Capitol Hill and of the firm’s placement of the country’s credit rating on negative watch in May due to the recent debt ceiling standoff. This isn’t the first time the U.S. credit rating has been downgraded to AA+, however. In 2011, S&P cited similar concerns when it stripped the U.S. of its triple-A credit rating. Caught by surprise by Fitch’s action, the Dow traded down 348 points on Wednesday. However, a slowing yet healthy jobs market, growing services and manufacturing activity, and strong big tech earnings helped put a floor under the selloff, resulting in the index finishing down -1.11% for the week.
Jobs Market Summer Slowdown
Nonfarm payroll growth held fairly steady in July, rising by 187K compared to June’s payroll gains which were revised lower to 185K from a previously reported 209K. The unemployment rate slipped to 3.50% as the labor force participation rate held at 62.6%, the fifth straight month at that level. Unlike the ADP report whose gains were primarily driven by hospitality and leisure, nonfarm payrolls were broad-based with health care, social assistance, financial activities, and wholesale trade driving hiring. The July slowdown also mirrors the JOLTs report (job openings and labor turnover survey) which showed job openings totaling 9.58 million in June, down from May’s 9.62 million openings. Year-over-year, job openings were down by 1.4 million, or 12.60%. That brings the openings per available worker to 1.6, down from a pandemic peak of 2.0. Average hourly earnings, a key figure for the Federal Reserve in its fight against inflation, increased 0.40% for the month which translates to a 4.80% annualized run rate. Although payroll gains have slowed from earlier in the year, hourly wages signal it’s still a tight jobs market. The Fed is sure to continue to weigh the deceleration in payroll gains numbers against the strong wage growth as it assesses whether additional rate hikes will be in store in September.
Rising Demand Fans Inflationary Pressures
Demand for services remained healthy in July as the ISM Services index hit 52.7. Numbers above 50 indicate expansion while numbers below indicate contraction. New orders, business activity, and employment continued to expand during the month. The employment gauge registered at 50.7, providing a mixed picture of the labor market. As some firms grew more cautious in adding to payrolls amid soft demand, others struggled to recruit and train, and/or lost workers to companies offering higher comp. Manufacturers also saw signs of increasing momentum as the ISM Manufacturing Index rose to 46.4 in July from 46.0 in June. Gains in new orders, production, and inventories drove the index’s gains. However, a -3.7 point decline in employment kept the sector in contraction for the month as factories struggled to determine the right amount of labor needed to meet demand. Inflationary pressures, however, show signs of increasing for both services and manufacturing. For services, the prices paid subcomponent reading moved up 2.7 points to 56.8. Inflation was broad-based as 15 of the 17 ISM services industries reported an increase in prices paid in July. Meanwhile, prices paid in the manufacturing sector rose 0.80 month-to-month to 42.6. The figure warrants watching for renewed signs of inflation.
Final Thoughts
Healthy economic reports and strong big tech earnings helped bolster markets following Fitch’s downgrade of U.S. debt on Wednesday. Sentiment improved as the week progressed as a number of bankers, economists, and business titans voiced their opposition to Fitch’s downgrade and defended the U.S.’s creditworthiness. Fitch’s decision to downgrade the U.S. stems from two sources. The first is seemingly an annoyance with our political parties’ increased inclination in using the U.S.’s creditworthiness for political purposes, pointing to erosion in confidence exacted during the recent debt ceiling standoff. The second, and more substantive, is the increasing deterioration in the country’s fundamentals. Healthcare, entitlements, and even the debt service itself has grown at an unsustainable rate over the last decade and, in particular, since the pandemic. Fitch’s political dysfunction argument is pretty weak, which is what many people have jumped on. Despite the debt ceiling brinksmanship, the U.S. did not default, nor was there any credible reason to think that the parties would ultimately have allowed that to happen. Everyone knows what is at risk if the U.S. were to do so. Fitch is correct on their second point, however. Debt and debt service as a percentage of GDP is as high as it has ever been. Higher interest rates only exasperate that problem. Furthermore, the political dialog is such that there is no reason to believe that our political parties can craft sustainable policies that will return us to a fiscally responsible state. Fitch is right. The U.S. may very well be an empire in decline – but if we are, we are centuries ahead of Europe and Japan. Credit ratings are relative and at the risk of sounding incredibly arrogant, it is hard to see another country that possesses the resources, educational level, population, and, frankly, a military to defend it all that rivals the U.S.. Woe be the credit agency that puts its trust and AAA label on China. For the time being at least, there is no alternative to the U.S. That may very well change over time but it won’t change overnight. Fitch’s downgrade oddly coincides with a time – in the short term – when signs are improving for a soft landing and a growing economy. Investor appetite for U.S. debt might change in time, but as noted investor Warren Buffet put it, “the only question for next Monday is whether we will buy $10 billion in 3-month or 6-month T-bills”. By Friday, investors had pretty well put Fitch’s downgrade on the back burner.
The Week Ahead
Inflation remains top of mind for markets as the latest consumer and producer price reports are set to be released. With prices remaining high, global demand for goods has taken a hit for much of 2023. We’ll see if the trend holds as the U.S. and China release global trade figures.
IRS Announces No RMD Requirements for Inherited IRAs in 2023 (Again)
The IRS announced last month that the agency will continue to delay enforcing new rules related to retirement accounts inherited after December 31, 2019. This announcement enables some individuals with inherited accounts to forgo taking a required minimum distribution (RMD) for 2023.
There has been a lot of confusion in recent years over the rules for recipients of inherited IRAs. In 2019, Congress passed legislation that removed what was known as the “stretch provision” for RMDs from most inherited IRAs. RMDs are congressionally mandated distributions from a qualified retirement plan, such as a traditional IRA or Simplified Employee Pension (SEP) plan. Prior to the legislative change in 2019, beneficiaries of an inherited IRA could “stretch” distributions from the inherited account over the course of his or her lifetime, thus delaying taxes and benefiting from tax-deferred growth. Under the law passed in 2019 as part of the SECURE Act, certain beneficiaries are required to distribute all the proceeds of a retirement account within a 10-year period. This is known as the “10-year-rule,” and it applies to “non-eligible designated beneficiaries” which includes heirs other than a spouse, minor children, disabled, chronically ill, or certain trusts and to accounts inherited after December 31, 2019. In cases where inherited retirement plans were particularly large, the 10-year-rule left beneficiaries with a huge tax bill.
The IRS announcement last month means that some inheritors who are subject to the 10-year-rule do not have to take RMDs for 2023. The guidance doesn’t say that the RMDs are waived, but there is no penalty for not taking them. Another aspect of the IRS rules surrounding inherited IRAs that has caused confusion is the requirement for a “non-eligible designated beneficiary” to begin taking RMDs immediately if the original owner of an IRA had already reached their “required beginning date” for taking the distributions. A lack of clarity around these changes led to many individuals missing RMDs over the past two years. If an individual skips an RMD, there is typically up to a 25% penalty that gets applied to what was supposed to have been distributed. The penalty may be reduced to 10% if the missed RMD is taken within a certain timeframe. The IRS announced in October 2022 that it would waive the penalties for missed RMDs for 2021 and 2022. The most recent guidance issued by the IRS basically extends the reprieve to 2023 for missed RMDs. The IRS indicated that final, longer-term guidance for inherited IRAs will come in 2024.
This IRS announcement doesn’t change the rules for “eligible designated beneficiaries” who generally must still take annual withdrawals over their expected lifetimes. The IRS waiver and delay in issuing final guidance offers individuals more time to consider a range of planning strategies around inherited accounts and for estate planning purposes. If you have questions about the tax impact of leaving IRAs and 401(k)s to beneficiaries or about inherited IRAs, please feel free to call our office at (214) 891-8131.