Endowus Portfolios Performance Update (July 2023) — The US Downgrade

Fitch lowers US rating from AAA to AA+

In a belated decision, Fitch Ratings, one of the top three global credit rating agencies, downgraded the US sovereign debt from the top rating of AAA to the next tier, AA+, on 1 August 2023. This was a surprise for many as the debt ceiling gridlock had been resolved two months prior. 

Fitch cited a few main reasons for the downgrade:

• Expected fiscal deterioration over the next three years
• A high and growing general government debt burden
• The erosion of governance relative to AA and AAA rated peers over the last two decades has manifested in repeated debt limit standoffs and last-minute resolutions

This downgrade comes more than 10 years after another credit rating agency, S&P, downgraded the US sovereign debt from AAA to AA+ with a negative outlook during a similar debt ceiling gridlock in 2011. S&P, at that time, cited heightened political polarisation and insufficient steps to get the nation’s budget under control. It went on to revise the outlook to stable in 2013 while keeping the AA+ rating unchanged.

With Fitch’s latest downgrade, Moody’s is now the only major credit rating agency to award the US with the coveted AAA rating.

Implications of the downgrade

After the downgrade by Fitch was announced, yields on the 10-year US Treasury bond rose by a small margin. Moreover, yields continued to rise on the back of several announcements — the US Treasury department announced a larger-than-expected auction of US bond sales across the maturity spectrum, and the Bank of Japan (BoJ) announced the beginning of the exit of yield-curve control. BoJ is one of the largest investors of US Treasury bonds. Concerns that there may be less demand for US Treasury bonds sent yields rising.

Despite the concern over a larger debt interest, the US Treasury market is the largest and most liquid in the world, and therefore it will likely remain the main safe haven asset, notwithstanding the downgrade.

• The US economy is still growing, inflation appears to have peaked, and unemployment is still low. 
• The US dollar (USD) remains the reserve currency of the world, and there is currently no good alternative. This should help to keep demand for US bonds relatively high and thus also keep yields from rising too much.
• The US debt market is the largest in the world, with about US$51.3 trillion dollars of outstanding debt, and its government debt stands at over US$26 trillion. As most investment mandates refer to Treasury securities specifically, rather than AAA-rated government debt, and as Fitch did not adjust its “country ceiling” at AAA, the impact on Treasury securities and on other AAA-rated securities issued by US entities should be limited.

We also believe there are a few key differences between the time S&P downgraded US Treasury to AA+ in 2011 versus the current downgrade by Fitch to AA+:

• First, the US economy is much more resilient this time around, with the US unemployment rate below 4% vs (9% seen in 2011). 
• Second, the spending cuts that ended the debt ceiling crisis of 2011 reduced federal spending by 0.7% of GDP the following year, while this time it is likely considerably lower.
• Lastly, even on a global level, 2011 was coming on the heels of a debt crisis in Europe. 

What this all means for our clients is that there is no need to start divesting investments that hold US Treasuries. US Treasury securities are still some of the safest and most liquid investments in the world and for now, nothing has changed.

July market commentary

The global equity markets continued to generate positive returns as investors stayed in risk-on mode. In a reversal from the first half of this year, emerging markets outperformed developed markets. The US had a moderate month in July, with the S&P 500 index returning about 3.2% in USD terms. In terms of factors, global value stocks did better than growth stocks by a slight margin, while small-cap stocks outpaced their large-cap peers, in a contrast to their performance in the first half of 2023. China had a strong July as the Chinese government announced measures to stimulate domestic consumption.

In the fixed-income markets, returns for global government bonds were generally negative in July 2023 as the risk-on sentiment bled over to fixed income. Corporate bonds did well, outperforming government debt while high yield across the Eurozone, US, and emerging markets did better than investment-grade debt.

Key performance highlights for the Endowus Portfolios in July

• The Flagship Portfolios outperformed both the global equity and fixed income markets, benefiting from structural tilts to value, small cap, and emerging markets on the equity front, and to corporate and emerging-market debt for fixed income.
• The ESG (Environmental, Social, and Governance) Equity Portfolio lagged its benchmark, facing challenges from its lack of exposure to the energy sector as well as security selection in industries such as financials and renewable energy. The ESG Fixed Income Portfolio outperformed its benchmark, helped by its allocations to emerging-market debt and corporate bonds, as well as its shorter duration positioning.
• All three Income Portfolios outperformed their benchmarks, enjoying tailwinds from multiple fronts in both the equity and fixed income segments.
• All three Cash Smart solutions continued to generate positive returns in July with high and stable payouts.

Endowus Flagship Portfolio

The Flagship 100% Equity Portfolio outperformed the global equity market in July

• The equity markets — represented by the MSCI All Country World Index (ACWI) — posted positive returns in July. However, in a reversal from previous months, emerging markets outperformed developed markets, and small-cap stocks beat their large-cap peers. Value stocks also did marginally better than growth stocks.
• The Flagship 100% Equity Portfolio benefited from all three structural biases, given its tilts towards small-cap stocks and value, and a slight overweight in emerging markets.

The Flagship 100% Fixed Income Portfolio outperformed the global fixed-income market in July

• The global fixed-income markets, as represented by the Bloomberg Global Aggregate Index, had a slightly negative month while the Flagship 100% Fixed Income Portfolio eked out a small positive return.
• The 100% Fixed Income Portfolio outperformed the global fixed-income market, helped by its larger allocations to corporate bonds and emerging-market bonds relative to the index. Emerging-market debt and corporate bonds generally outperformed government debt in July.

Endowus ESG Portfolio

The ESG 100% Equity Portfolio delivered positive returns in July, albeit lagging the broader equity market

• The ESG 100% Equity Portfolio had no allocation to the energy sector, which hurt the portfolio’s performance in July as the energy sector turned out to be the best-performing equity sector for the month.
• The portfolio’s selected positions in the financial sector and the renewable energy segment dragged on relative performance as well.

The ESG 100% Fixed Income Portfolio outperformed the broader fixed income market by 0.7%

• All three underlying funds in the ESG 100% Fixed Income Portfolio outperformed during the month. 
• The portfolio’s shorter-duration positioning, as well as exposure to emerging-market bonds and both investment-grade and high-yield corporate bonds, contributed to relative performance. 

Endowus Income Portfolios

The Stable Income Portfolio outperformed the broad fixed-income market in July by 0.8 percentage point

• The portfolio’s shorter-duration position helped as rates moved higher in the month of July. 
• Its allocation to emerging-market bonds contributed positively to the performance, as emerging-market debt recorded another positive month.
• The portfolio’s allocations to flexible bond funds — the PIMCO GIS Income Fund and the AB American Income Portfolio Fund – also contributed to relative performance.

The Higher Income Portfolio outperformed the 20-80 benchmark in July by 1 percentage point

• On the fixed-income side, the biggest contributor to relative performance was the portfolio’s allocation to high-yield bonds, as the high-yield market rallied further in July. The portfolio’s allocations to the AB American Income Portfolio Fund and emerging-market bonds were also meaningful contributors to performance for the month. 
• On the equity side, the portfolio’s allocation to emerging-market equity contributed to relative performance. In addition, the portfolio benefited from being SGD-hedged as the USD depreciated against SGD in July. 

The Future Income Portfolio outperformed the 40-60 benchmark in July by 0.6 percentage point

• On the fixed-income side, similar to the other two income portfolios, the Future Income Portfolio’s allocation to emerging-market bonds, the PIMCO GIS Income Fund, and high-yield bonds all contributed to relative performance. 
• On the equity side, the portfolio performed in line with the broad equity market, as represented by the MSCI All Country World Index (ACWI).

All three Income Portfolios are achieving their payout targets 

• Actual payouts have remained stable despite the fluctuation of prices across the three portfolios. Volatility in price returns will result in mark-to-market changes (decrease or increase) in the portfolio value, but will not impact the actual coupon payments or dividend payouts from the underlying funds. 
• As the chart below shows, the annualised payout yields for the portfolios have been rising as a function of stable monthly payouts and lower net asset values from late 2021 to around October 2022. Since then, yields have remained elevated compared to historical levels.
• Yields in the fixed income market have risen meaningfully following the increase in global interest rates, creating a higher yield environment for income-seeking investors. 

Endowus Cash Smart Portfolios

Cash Smart Secure continued to generate stable and positive returns

• The Secure portfolio delivered positive returns in July 2023.
• Its underlying funds, the Fullerton SGD Cash Fund and the LionGlobal SGD Enhanced Liquidity Fund, continued to do well through their ultra-short duration positioning.

Cash Smart Enhanced delivered moderately positive returns in July

• One of the Enhanced portfolio’s underlying funds, the UOBAM United SGD Fund, participated in the recent upswing in the Asian investment-grade market. This contributed to the Enhanced portfolio’s positive July performance.

Cash Smart Ultra performed favourably in July

• The Ultra portfolio is the top-performing Cash Smart solution year-to-date, proving its potential for high returns, albeit with a higher level of volatility as intended.
• The portfolio benefited from its allocations to underlying funds such as the Fullerton Short Term Interest Rate Fund and the PIMCO GIS Low Duration Income Fund, which were able to benefit from the favourable returns in the Asian investment grade and US securitised markets during the month.

Cash Smart projected yields have been on an upward trend with rising interest rates

• The fall in bond prices has a negative mark-to-market impact, but this results in a higher yield-to-maturity of the bonds that make up the portfolios.
• The rising rate environment provides an opportunity for the underlying funds to reinvest and allocate the coupon payments and cash from maturing bonds to higher-yielding bonds. The managers of the underlying funds will continue to take advantage of this environment as they reposition their funds over the next few months.

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