X marks the spot
The US debt ceiling drama that has been unfolding has been the subject of many headlines over the past few weeks. But, what is the debt ceiling and why is there a standoff? The debt ceiling is essentially a limit on the amount of debt that can be borrowed by the US Treasury. The US government issues bonds to sell to investors around the world to meet its obligations such as paying social security benefits, interest on its current national debt, and so on. Currently, the ceiling stands at about US$31.4 trillion, and the US hit this limit in January 2023.
The US Treasury Department has now resorted to “extraordinary measures” to continue meeting the US’ obligations. This means it is now running down its cash balance until there is none left. How long the cash balance will last is hard to determine. Janet Yellen, the US Treasury Secretary, has remarked that the X-date — which is when the US is no longer able to pay its bills — could be as early as 1 June 2023.
Given that the debt ceiling is entirely self-inflicted by the US, why is it so difficult to reach an agreement to increase this artificial (and arbitrary) limit? The Democratic party currently has control of the US Senate while the Republicans are in control of the House. Democrats want to raise the debt ceiling without any conditions attached, but Republicans want spending cuts to food stamps, government aid, and renewable energy tax breaks in order to raise the debt ceiling. With neither party willing to concede, they have now reached stalemate.
Will the US default on its debt?
The US has never had a default. But we’ve seen this show before — many times, in fact. The debt ceiling has been increased 102 times since World War II. However, the situation is made much worse when the Senate and the House are each controlled by different parties. The most recent and perhaps most relevant episode occurred in 2011 when the ceiling was raised just two days before the X-date. The US federal government’s credit rating was then downgraded from AAA to AA+ by a major credit rating agency.
If the debt ceiling is not raised in time, the risk of default could increase exponentially. The impact to the US and global economy could be catastrophic, even though the US would eventually be able to meet its obligations. There are some who argue that the US Treasury and the government could find ways to mitigate the potential fallout, but no one can clearly predict how that would play out.
In 2011, we saw the S&P 500 index decline by about 19% from the peak in April 2011 to the trough in October 2011. By February 2012, the US market had bounced back up to its level in February 2011.
The two main takeaways from history are:
- Policymakers have generally come to a compromise in order to prevent an economic catastrophe, and
- The impact may be more limited and transitory in nature.
Market reactions to the drama
Even with the brouhaha around the US debt ceiling saga, the CBOE Volatility Index, or VIX, has been lying low.
As we draw closer to the X-date, short-term US Treasury bills with a maturity date around or after the X-date have seen their yields increase. However, yields on longer-dated Treasury bonds remained largely unchanged.
Aside from T-bills, there was significant movement in credit default swaps (CDS) on US debt as the cost of insurance on US debt spiked.
With diversification, long-term investors can rest easy
Most analysts and market experts believe the risk of a US debt default is very low. The situation becomes less bleak and more manageable if you look at the average expected outcome of possible scenarios encompassing a resolution to the US debt ceiling issue and a catastrophic default, and taking into account all the probabilities.
Moreover, even in the unlikely outcome of a technical US debt default, we believe the impact may be short-lived as we have seen with other global events in history. A study of bear markets and subsequent recoveries from the 1800s to early 2020 by Goldman Sachs Investment Research showed that the average event-driven bear market tended to last no more than 10 months, and took fewer than 20 months to recover.
Diversification, diversification, and diversification in all aspects is most likely the best defence against uncertainty. If your risk tolerance and risk appetite allow for it, making sure you have both equity and fixed income in your portfolio could help.
April market commentary
Both the global equity and the fixed income markets had a positive month in April, albeit a small gain. The MSCI All Country World Index (net div, USD) rose 1.4% while the Bloomberg Global Aggregate Index (USD, hedged) gained 0.5%.
The best-performing region for the month was Europe. The MSCI Europe Index (net div, USD) posted a 4.1% gain, the S&P 500 rose 1.6% and the MSCI AC Asia Index (net div, USD) fell 1.2%. Gross domestic product (GDP) data showed that the eurozone economy grew by about 0.1% after being flat in the fourth quarter of 2022. The aggregate eurozone GDP growth figure was boosted by relatively strong expansion in Spain and Italy. In the UK, financials was one of the top performing sectors for the month as fears around the banking crisis receded somewhat. The March inflation number was higher than January’s, adding to speculation that the Bank of England may have to increase rates again to tamper inflation.
The US had a lacklustre month as weaker economic data weighed on investors’ minds. The collapse of First Republic Bank and its subsequent acquisition by JP Morgan caused some uneasiness, but the markets digested and took the news in stride. The Fed raised rates again in May, by another 25 basis points, but signalled that it might pause on subsequent hikes.
Emerging markets, as a region, retracted 1.1%, underperforming the developed markets by about 2.9%. The weak performance was largely due to China, falling more than 5% in April. The renewing of US-China tensions was one factor contributing to the decline.
In a reversal from March, value stocks made a comeback and outperformed growth stocks during the month of April. Global large-cap stocks continued to outpace small-cap stocks.
In fixed income, bond returns were generally flat after the rally in March because of lower bond yields. Credit markets were generally positive in April.
The S&P GSCI — a benchmark for investment in the commodity markets — saw a small decline of about 0.8% in April as agriculture, energy and industrial metals posted negative returns. Crude oil and gold rose modestly for the month.
Key performance highlights for Endowus portfolios in April
- The Flagship Portfolios posted positive gains in April, bringing the year-to-date returns of the equity portfolio to 7.1% and the fixed income portfolio to 2.9%.
- The ESG (environmental, social, and governance) Portfolios also delivered positive returns during the month. Year-to-date returns also remained robust, with a 7.8% gain for the equity portfolio and a 2.5% return for the fixed income portfolio.
- All three Income Portfolios continued to post positive returns, while also meeting their payout targets.
- All three Cash Smart Portfolios had a positive month in April, continuing to deliver strong year-to-date returns and outpacing the SIBOR cash benchmarks.
Endowus Flagship Portfolio
The Flagship 100% Equity Portfolio lagged the global equity market in April
- Similar to the previous month, the global equity markets — represented by the MSCI All Country World Index (ACWI) — generally posted positive returns. In a reversal from March and most of Q1, value stocks outpaced their growth peers by about half a percentage point. Emerging markets underperformed developed markets and global small-cap stocks generally underperformed large caps.
- The Flagship 100% Equity Portfolio underperformed its benchmark by about 40 basis points (bps), hamstrung by a few structural biases. The portfolio’s tilt to small-cap stocks via the Dimensional funds, as well as slight overweight allocations in emerging markets and the Asia Pacific region, all detracted from relative performance.
The Flagship 100% Fixed Income Portfolio performed in line with the global fixed income market in April
- The global fixed income markets, as represented by the Bloomberg Global Aggregate Index (hedged, SGD), were almost flat for the month, eking out a small positive return of 0.4% in SGD terms.
- The Flagship 100% Fixed Income Portfolio was flat against its benchmark for the month. The Dimensional Global Core Fixed Income Fund and the Amundi Index Global Agg 500m Fund outperformed the Bloomberg Global Aggregate Index, but the positive impact was offset by the relative underperformance of the three PIMCO funds.
Endowus ESG Portfolio
The ESG 100% Equity Portfolio delivered positive returns in April, albeit lagging the MSCI All Country World Index (ACWI)
- The portfolio has a bias to companies that benefit from efforts to accommodate or limit the impact of global climate change, primarily through the allocation to the Schroder ISF Global Climate Change Fund. This exposure was the primary source of weakness in April after a strong first quarter in 2023, detracting from the relative performance.
The ESG 100% Fixed Income Portfolio delivered strong returns and outperformed the Bloomberg Global Aggregate Index
- The portfolio’s overweight positions in credit and emerging markets contributed positively to its performance.
- The strongest performer was the United Sustainable Credit Income Fund. The fund invests in companies that contribute to realising the UN Sustainable Development Goals across all fixed income segments, including investment grade, high yield, and emerging-market corporate bonds. It benefited from the rebound in the bank debt segment after a volatile March.
Endowus Income Portfolios
The Stable Income Portfolio outpaced the Bloomberg Global Aggregate Index in April
- The portfolio’s overweight position to riskier sectors — such as Asian credit, emerging-market bonds, and corporate credit — helped as credit rallied on investors’ improved risk appetite during April.
The Higher Income Portfolio delivered strong performance and outperformed the 20-80 Equity-Fixed Income Composite Index
- On the fixed income side, similar to Stable Income, the Higher Income Portfolio benefited from an overweight allocation to riskier sectors such as corporate credit and, in particular, the high-yield bond segment.
- On the equity side, allocation to and fund selection in real assets equities boosted performance, while an allocation to emerging-market equities hurt. Emerging-market equities declined in April and underperformed relative to developed markets as tensions between US and China rose.
The Future Income Portfolio delivered positive returns, but lagged the 40-60 Equity-Fixed Income Composite Index
- The fixed-income sleeve of the portfolio performed in line with the Bloomberg Global Aggregate Index.
- The underperformance relative to the 40-60 Equity-Fixed Income Composite Index was largely driven by the equity portion of the portfolio. Its overweight allocations to emerging-market and Asian equities detracted from relative performance.
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 a mark-to-market change (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, and have been stable since markets rebounded in Q4 2022 and year-to-date 2023.
- 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 and Enhanced both generated positive returns in April
- The ultra short-duration approach of the Secure solution continued to prove beneficial. Its underlying funds — Fullerton SGD Cash Fund and LionGlobal SGD Enhanced Liquidity Fund — capitalised on the higher rates in the market.
- The Enhanced portfolio also benefited from an allocation to Asian credit via the United SGD Fund.
Cash Smart Ultra delivered consistently higher month-on-month returns
- All the underlying funds in the Ultra portfolio posted positive returns in April.
- The Nikko Shenton Income Fund was the primary contributor, receiving a boost from the optimism in Asia and China. Additionally, the PIMCO Low Duration Income Fund had a good month in April, driven by an allocation to the securitised segment.
Cash Smart projected yields have been on an upward trend with rising interest rates
- The fall in bond prices has had a negative mark-to-market impact on the portfolios, but, in turn, this has resulted in a higher yield-to-maturity of the bonds that are in 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 for the next few months.
Read more: Beyond fixed deposits, SSBs, T-bills — Endowus cash management solutions (April 2023)
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