Strong risk-on tailwinds that developed throughout the first half of 2023 persisted into July, with global investors embracing resilient U.S. economic data, an easing of inflationary pressures, and a potential end in sight for the Fed’s historic tightening campaign. Performance across global equities was overwhelmingly positive on the month, particularly within the emerging markets, which nearly doubled the return generated by U.S. large cap. The riskon market sentiment was also evident across the bond market, with performance favoring credit-oriented sectors, sending credit spreads to well-below historical averages. Real asset returns were similarly positive in July, particularly among the commodity indices, as the Bloomberg Commodity Index posted a 6.3% gain, the strongest monthly performance since March 2022. A further rise across commodity prices, however, could support a reacceleration in headline inflationary pressures, in turn potentially leading the Federal Reserve (Fed) to remain on its tightening path.
Fitch Strips U.S. of 'AAA' Credit Rating, Citing Near- and Long-Term Fiscal Challenges
On August 1, Fitch Ratings stripped the U.S. of its ‘AAA’ long-term credit rating, with a one-notch downgrade to ‘AA+’ citing “expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA' rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.” (Source: Fitch Ratings, 8/1/2023)
Through January, gross government debt as a share of nominal gross domestic product (GDP) stood just below 120%, a ratio modestly below the 135% peak established during the brief COVID-19 economic downturn and a level anticipated to increase further during the next economic downturn. Moreover, at 118.6%, federal debt-to-GDP is more than 20 percentage points higher than the last time the U.S. suffered a credit rating downgrade in August 2011 by Standard and Poor’s.
In addition to a growing government debt burden and erosion of fiscal governance, Fitch cited “expected fiscal deterioration over the next three years.” Similar to the current elevated ratio of government debt relative to GDP, the Treasury’s budget deficit as a percentage of GDP also paints a worrisome picture of the country’s fiscal health. Despite the economy still in the midst of an economic expansion, the Treasury’s budget deficit as a share of GDP has deteriorated in recent months and is nearing a double-digit reading.
Through June, the budget deficit, at 8.5% of GDP, is trending in a particularly unfavorable direction. Excluding the COVID-era extraordinary fiscal actions aimed at shoring up the U.S. economy and the brief, sharp decline in GDP growth, the current outsized budget deficit relative to GDP is closing in on the 10% reading that was breached in 2010 as the economy was clawing itself out of the 2008-2009 Global Financial Crisis. Moreover, due to a sharp rise in Treasury interest rates and a ballooning debt overhang, the Congressional Budget Office (CBO) anticipates that the U.S. could spend more than $1 trillion annually on interest expense over the coming ten years.
In summary, financial market performance was significantly positive in July, as risk-on sentiment supported performance across most major asset classes and categories, while a modest monthly rise in Treasury rates negatively impacted performance across the higher quality, rate-sensitive sectors of the bond market. Despite 12 years having passed since Standard and Poor’s (S&P's) downgraded the U.S. from ‘AAA’ to ‘AA+', Fitch Ratings finally followed in S&P’s footsteps by stripping the U.S. of its ‘AAA’ long-term sovereign credit rating, with an early-August one-notch downgrade to ‘AA+’ amid current and anticipated fiscal challenges.
INDICES
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
Bloomberg Fixed Income Indices is an index family comprised of the Bloomberg US Aggregate Index, Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, Municipal Index, High-Yield Index, Commodity Index and others designed to represent the broad fixed income markets and sectors. On August 24, 2016, Bloomberg acquired these long-standing assets from Barclays Bank PLC. and on August 24, 2021, they were rebranded as the Bloomberg Fixed Income Indices. See https://www.bloomberg.com/markets/rates-bonds/bloomberg-fixed-income-indices for more information.
The CBOE Volatility Index (VIX) is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index option bid/ask quotes. The Index uses nearby and second nearby options with at least eight days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
FTSE Real Estate Indices (NAREIT Index and EPRA/NAREIT Index) includes only those companies that meet minimum size, liquidity and free float criteria as set forth by FTSE and is meant as a broad representation of publicly traded real estate securities. Relevant real estate activities are defined as the ownership, disposure, and development of income-producing real estate. See https://www.ftserussell.com/index/category/real-estate for more information.
HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc. (HFX), and are used by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 2,000 funds listed on the internal HFR Database. The HFRI Fund of Funds Composite Index is an equal weighted, net of fee, index composed of approximately 800 fund- of- funds which report to HFR. See www.hedgefundresearch.com for more information on index construction.
J.P. Morgan’s Global Index Research group produces proprietary index products that track emerging markets, government debt, and corporate debt asset classes. Some of these indices include the JPMorgan Emerging Market Bond Plus Index, JPMorgan Emerging Market Local Plus Index, JPMorgan Global Bond Non-U.S. Index and JPMorgan Global Bond Non-U.S. Index. See www.jpmorgan.com for more information.
Merrill Lynch high yield indices measure the performance of securities that pay interest in cash and have a credit rating of below investment grade. Merrill Lynch uses a composite of Fitch Ratings, Moody’s and Standard and Poor’s credit ratings in selecting bonds for these indices. These ratings measure the risk that the bond issuer will fail to pay interest or to repay principal in full. See www.ml.com for more information.
Morgan Stanley Capital International – MSCI is a series of indices constructed by Morgan Stanley to help institutional investors benchmark their returns. There are a wide range of indices created by Morgan Stanley covering a multitude of developed and emerging economies and economic sectors. See www.morganstanley.com for more information.
The FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs.
Russell Investments rank U.S. common stocks from largest to smallest market capitalization at each annual reconstitution period (May 31). The primary Russell Indices are defined as follows: 1) the top 3,000 stocks become the Russell 3000 Index, 2) the largest 1,000 stocks become the Russell 1000 Index, 3) the smallest 800 stocks in the Russell 1000 Index become the Russell Midcap index, 4) the next 2,000 stocks become the Russell 2000 Index, 5) the smallest 1,000 in the Russell 2000 Index plus the next smallest 1,000 comprise the Russell Microcap Index, and 6) U.S. Equity REITs comprise the FTSE Nareit All Equity REIT Index. See www.russell.com for more information.
S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation, among other factors by the S&P Index Committee, which is a team of analysts and economists at Standard and Poor’s. The S&P 500 is a market-value weighted index, which means each stock’s weight in the index is proportionate to its market value and is designed to be a leading indicator of U.S. equities, and meant to reflect the risk/return characteristics of the large cap universe. See www.standardandpoors.com for more information.
Information on any indices mentioned can be obtained either through your advisor or by written request to information@feg.com.
DISCLOSURES
This report was prepared by FEG (also known as Fund Evaluation Group, LLC), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department.
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Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
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Past performance is not indicative of future results.
Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors.
All data is as of July 31, 2023 unless otherwise noted.