Fabian Estevez

In recent days, Fitch Ratings downgraded the US sovereign credit rating from AAA to AA+. This action was not entirely a surprise, as Fitch had placed the rating on negative review during the debt ceiling negotiations at the end of the second quarter of this year. In 2011, Standard & Poor’s downgraded the rating from AAA to AA+, within a somewhat similar political environment. Below, we share certain points that we consider relevant under a FAQ format.

Is the downgrade a significant event?

While initial sentiment suggested that the rating action does not represent a major event for now, because the economy has performed much better than expected throughout this year, Fitch’s action is a reminder that fiscal dynamics are on a trajectory that will require more attention over a longer-term horizon.  In this sense, the downgrade was based on the following reasons: erosion of governance (poor fiscal management and constant political clashes over the debt limit), higher fiscal deficits* for the following years, and an overall increase in public debt. The agency projected debt-to-GDP levels to rise significantly, potentially reaching 118% by 2025. This debt ratio is higher than the 39.3% average of other AAA-rated governments.

What other factors could create more uncertainty about U.S. debt?

So far, it seems that the markets have finished assimilating the downgrade. However, we believe that new episodes of volatility and nervousness among investors cannot be ruled out if the following situations arise:

• Moody’s downgrade.  This action by Fitch represents the second time in U.S. history that an agency has downgraded a credit rating. As of now, Moody’s is the only agency with an AAA rating. If Moody’s were to downgrade, the U.S. would no longer be considered AAA, which could impact the mandates that some funds and investors might hold, modestly reducing the attractiveness of owning U.S. Treasuries.
• Economic crisis: In the event that the economy experiences a deeper and more lasting recession, tax revenues could be affected, while spending could increase. This mix would mean that the debt trajectory estimated by the rating agencies could turn out to be more conservative than expected.

Assuming that the economy does not experience a significant recession that causes accelerated deterioration in the U.S. fiscal profile, then this would not be expected to imply a long-lasting problem.

What was the impact on financial markets?

• Equity Market: The news generated a very short-term correction. However, optimism about lower recession expectations, and the possibility that the FED has concluded its interest rate hike cycle, moderating inflation and a defensive performance in corporate earnings, continue to dominate the market’s good mood.
• Fixed Income: Although the instinctive reaction drove Treasury yields up more than 10bp since the announcement, particularly longer maturities, it appears that this dynamic will not have a lasting impact on markets primarily because this cut is still within the parameters of most mandates, so there would not be a massive sell-off by fund managers. In addition, the US continues to have robust creditworthiness and enjoys the most liquid and largest bond market in the world.

*Fiscal deficit: refers to when the government’s total expenditures exceed its revenues (excluding financing).

The S&P 500 Performance Following The Last Credit Downgrade In 2011

Source:  Raymond James

As part of our monitoring of alternative investments, following is an update on the dynamics of the real estate sector. As the third quarter of 2023 progresses, global real estate valuations have experienced a significant correction due to changes in capital market conditions over the past year.

Transaction and investment volumes have declined, reaching levels similar to those recorded during the first quarter of the pandemic, as investors adjust to a higher interest rate environment. Under this context, in the first quarter, transactions totaling US$210bn were completed, representing two-thirds of the long-term quarterly average. In this regard, early signs for activity in April and May confirm that the market maintained low activity.

Valuations and prices have shown three quarters of downward correction in most markets, with the fourth quarter of 2022 being the most pronounced. During the nine months through March 2023, valuations in the MSCI Global Property Fund Index, which represents more than 110 regional real estate funds, declined by an average of -7.5%.

Although the direction of the correction is similar everywhere, there are significant regional differences. The UK market, for example, leads the correction with a decline of more than -22% in the 11 months up to May 2023, while Australia shows remarkable resilience with only a -1% correction recorded in April and May.

This environment of valuation corrections has also made it difficult for fund managers to raise capital. During the first quarter, capital raised in private real estate funds declined 78% compared to the fourth quarter of 2022, with only $12.4 billion of capital committed.

Uncertainty about how much further the valuations in any part of the market will have to be corrected depends on a number of factors, including the future path of interest rates and the local outlook for rent growth, as well as the level of inflation in the global economy.

If the narrative of a “soft landing” for the global economy prevails, real estate investor sentiment is likely to improve toward the latter months of 2023. In such a case, the turnaround in activity is likely to be rapid, as investors will seek to capitalize on an attractive valuation environment.

Source:  RCI, Mercer Global Market Summary July 2023.

Source:  MSCI, Mercer Global Market Summary July 2023.

After the June pause and in line with market expectations, the FED increased by a quarter of a percentage point (25bp) the target range for the reference rate to 5.25 – 5.50%, a 22-year high. This move represented the eleventh increase since March 2022, when the range was near zero. The decision was unanimous.

Inside, the statement revealed language very similar to that of June, where it ratified that in order to determine the degree of additional monetary policy tightening that might be appropriate to eventually bring inflation back to 2%, the Committee will take into account all the measures that have been implemented so far, the lags with which monetary policy affects economic activity and inflation, as well as the development of economic and financial factors. It will also continue to evaluate additional information as it emerges and its implications. These sentences suggest that officials are keeping their options open to implement another hike at their next meeting in September, or to pause or omit an increase depending on incoming data and information.

On the other hand, the Committee described that recent indicators reveal that economic activity has been expanding at a moderate pace (in the previous release it referred to a modest expansion). Job creation has been solid in recent months and the unemployment rate has remained low. However, inflation remains elevated. Finally, he noted that the U.S. banking system is strong and resilient.

During his press conference, Jerome Powell stressed that future decisions will be data dependent. Therefore, he reiterated that the options for the FED are open. In particular, he commented that a decision has not yet been made for the next meetings, referring to the next meeting on September 20. In this sense, he communicated that the decision to increase or maintain the rate at that meeting will be influenced by the large amount of information that will be known by that date.

Expectations for the Federal Funds Rate

Source: JP Morgan

China’s economy grew 6.3% annually during the second quarter of this year, which was below expectations of 7.3%. On a quarterly comparison, growth was 0.8%, which also represented a weaker reading than the 2.2% advance recorded in the first quarter. After disappointing economic data for April and May, June’s figures showed a moderate improvement, especially due to government policy support in infrastructure and manufacturing. However, the housing market and private sector fixed asset investment remained weak. On the consumer side, June retail sales grew 3.1% annually (vs. 3.2% estimated), with hotel, sports and entertainment products and alcohol and tobacco growing the most, while automobiles, office products and daily use items experienced a decline. Similarly, online sales decelerated versus May’s figures, despite having risen 6.7% annually.

On the other hand, labor conditions continued to show mixed results. While the survey-based urban unemployment rate remained unchanged at 5.2%, unemployment among the younger population (16 to 24 years old) registered a new record rate of 21.3%. In this sense, the higher youth unemployment rate reflects a structural mismatch in the labor market and an unbalanced recovery of the economy.

The spokesman of the National Bureau of Statistics, Fu Linghui, pointed out that the country is facing a complex geopolitical and economic environment due to tensions with the United States and weakness in exports and the real estate sector, respectively. He also stated that China can still achieve its full-year growth target of around 5%. However, when asked about the outlook for the second half of the year, spokesman Fu commented that he expects real estate investment to remain low in the near future and that youth unemployment could rise further before declining after August.

That said, we do not rule out the government stepping up policy easing measures after this disappointing GDP data, including: further easing of fiscal and monetary policy (more rate cutbacks and relaxation of reserve requirements for banks), and nationwide support on housing policies, likely to include relief on down payments.

Unemployment rate (%)

Source: JP Morgan

GDP Growth (%)

In the graphic:

• %oya: refers to annual percentage change.
• %q/q: refers to the quarterly percentage variation.

Source: JP Morgan

The consumer price index accelerated 0.2% monthly in June (vs. 0.3% expected). As a result, annual inflation was 3% (vs. 3.1% expected and 4% in May), its lowest level since March 2021. Core CPI inflation, which excludes food and energy, rose 0.2% in the month and was better than expected. It is worth mentioning that June’s variation represented the lowest monthly change since 2021. On an annual basis, core CPI stood at 4.8% (vs. 5% expected and 5.3% in May).

Once again, the index for shelter was the main contributor to the monthly increase, accounting for 70% of the increase.  In this context, in the month it advanced 0.4% (+7.8% annually). On the other hand, the food index decelerated its advance to 0.1% (+5.7% annually); where food at home remained unchanged during the month (+4.7% annually), while food away from home increased 0.4% (+7.7% annually). As for the energy index, this component rose 0.6% in the month. However, in its annual variation, it posted a drop of 16.7%. Particularly noteworthy were the annual decreases of 26.5% and 36.6% in gasoline and fuels, which helped to offset the 5.4% annual increase in electricity. Finally, airline fares, communication, used cars and trucks, and household furnishings were some of the components that decreased during the month.

In summary, these figures can be interpreted as positive, providing some relief for the Federal Reserve as it confirms that inflation continues to decline from a peak of about 9% annually a year ago, the highest since November 1981. However, there is still some way to go, as core CPI remains elevated, reflecting pressures in the index for shelter, combined with the employment situation remaining strong. In June alone, 209,000 new jobs were created, the unemployment rate stood at 3.6% and wage increases were observed in the order of ~4.4% annually. Therefore, the consensus discounts with a 92% probability that the Fed will implement a 25bp hike at its next meeting on July 26th.

CPI monthly change (%) over the last twelve months

Source: U.S. Bureau of Labor Statistics     

Change (%) in the last twelve months in CPI and Core CPI

Source: U.S. Bureau of Labor Statistics

The corporate reporting season will begin in the coming weeks. In this sense, the consensus foresees that S&P 500 companies’ earnings would have experienced an annual contraction of 6.5% during 2Q23 (vs. an expected contraction of 4.7% at the beginning of 2Q23).

This estimate contrasts negatively with the 10-year average earnings growth rate of 8.5% and, if it materializes, could represent the largest annual decline reported since the second quarter of 2020 (-31.6% annually). It could also mark the third consecutive quarter in which earnings are down in its annual variation rate. Seven of the eleven sectors are expected to post earnings growth, led by the consumer discretionary sectors (+25.8% annually); driven by a rebound in the sub industries of retail, hotels, restaurants and automotive components. On the other hand, it is followed by the communication services sector (+12.8% annually) thanks to the performance of wireless telecommunication services, entertainment and interactive media and services. Conversely, the energy sector is expected to register the largest decline in profits (-47.3% annually) of the eleven sectors, due to a lower average oil price (US$74.01 so far in 2Q23 vs. US$108.5 in 2Q22). Likewise, the materials and healthcare sectors reported declines of 30.3% and 16.7%, respectively.

In terms of sales, a marginal decrease of 0.4% annually is looming; where if confirmed, it would mark the first time that the index reports an annual decrease in sales since the third quarter of 2020 (-1.1%). With this mix of factors, the profit margin would stand at 11.4%, which represents a contraction of 80bp versus last year’s 12.2%. Compared to the 1Q23 profit margin, there would be a small contraction of 10bp. 

JP Morgan will give the starting signal on July 14; therefore, investors will be particularly attentive to the evolution of the season and leads for the remaining quarters, given the strong rebound that has been observed in the markets throughout this year.

Following up on our comments about the possible benefit that the Artificial Intelligence (AI) application would bring to the investment analysis process, now we will share some perspectives about how innovation represents a powerful force for driving change in healthcare, and AI is well positioned to revolutionize the sector. Healthcare systems contain large amount of data that can be extracted to obtain information. Pharmaceutical companies are always searching for ways to speed up lengthy drug development processes. In theory, AI could help promote more effective management across the industry, helping to obtain the right treatments in the adequate quantities for the right patients. Under this context, the initial application that the AI could have within the healthcare industry would involve the following areas: 

• Research and Development (R&D): AI could potentially be used to improve the success rates of the medications in clinical trials, even though this process could take years. 
• Clinical trials: Implementing AI in logistic areas could expedite the clinic trial process and improve overall efficiency. Particularly, it could improve this process by helping companies to identify clinical sites that can enroll patients more quickly, as well as identify underperforming sites that need improvement. 
• Commercial Development: AI could help companies identify physicians and specialists who could be the main candidates to promote a new product launch and minimize the obstacles to reaching the market. Also, AI could help companies focus on the most effective events to generate enthusiasm and expectation around a new medication. 
• Complementing the human experience: Every patient wants to obtain the best diagnosis from their doctor, here AI could make a great difference. With the help of AI, a physician would have the potential to improve the diagnosis based on a patient’s uncommon symptoms. By leveraging AI technology to improve diagnostic accuracy, healthcare providers can offer better conclusions and strengthen their outcomes.

As mentioned above, these points could be the first approach of AI to the sector. However, this process will take time and its progress will be subject to constant evaluations, or even regulations, to ground its capacity to produce better results and economic benefits.  What is a fact is that these new technological capabilities are here to stay. 

In this regard, UnitedHealth Group expressed that AI could help reduce the time needed to turn data into information, leading to a better understanding of all the factors that affect a person’s health. When implemented strategically, this technology can lead to better healthcare decision making and lower costs for companies.

After inflation decelerated to an annual rate of 4% during May (the lowest since March 2021) and in line with expectations, the FED kept the reference rate range unchanged at 5 – 5.25%. With this, it put a halt to the cycle of eleven consecutive increases. The decision was unanimous.

Inside the statement, the Federal Open Market Committee (FOMC) emphasized that keeping the reference rate range stable allows it to evaluate additional information and its implications for monetary policy. Additionally, it expressed that, to determine the degree of additional tightening that could be appropriate, the Committee will take into account everything that has been implemented so far, the lags with which monetary policy affects economic activity. In particular, it will evaluate the readings on labor market conditions, inflationary pressures and inflation expectations, and financial and international developments. In this context, it reiterated its firm commitment to return inflation to its 2% target.

On the other hand, the FED updated its macroeconomic forecasts; where it highlighted that the federal funds rate could close the year at 5.6% (vs. 5.1% projected in March). This scenario represents another two 25bp increases eventually. For 2024, the new estimate was also revised upwards to 4.6% from 4.3%; however, the outlook for lower rates compared to 2023 is maintained (5.6% vs. 4.6%). Regarding the economic panorama, the expected growth for this year was positively revised to 1% from 0.4%. In this regard, the Committee members were more optimistic about labor conditions, forecasting an unemployment rate of 4.1% by the end of the year (vs. 4.5% projected in March). However, by 2024 there could be a deterioration, which would bring the unemployment rate to 4.5%. Finally, for core inflation (excluding food and energy), the new estimate was revised slightly upward to 3.9% from 3.6% in March. Positively, the expectation for 2024 remained unchanged at 2.6%.

During his press conference, Jerome Powell reported that the full effect of all the monetary tightening is not yet reflected, although much ground has been gained in the battle to contain inflation.

Within fundamental analysis, there are two key factors that influence the yield of a share: the earnings generated by the company and how investors value those earnings. In this context, one way to determine the value of a share is through a financial ratio known as the Price/Earnings multiple (P/E ratio). In this tutorial, we will detail the most relevant points surrounding this useful metric:

What are its components? The P/E is calculated by dividing the price of a share (“Price”) by a company’s annualized earnings per share (“EPS”). The P/E can be constructed with the known earnings over the last twelve months (Trailing P/E) or with the expected earnings for the next 12 months (Forward P/E). In this sense, optimism can lead to an expansion in the P/E, being a period in which perceptions about a company improve and, as a result, investors are willing to pay more for each unit of earnings. On the contrary, when investors’ expectations are negative, they will seek to pay less for each unit of earnings, causing a contraction in the P/E.

How to analyze the P/E? Firstly, it is necessary to observe whether the P/E value is “high” or “low”, to eventually determine an absolute valuation, which is nothing more than comparing the current P/E with its historical average (10, 15, 20 years). To complement the analysis, the company’s current P/E should be compared with that of similar companies or companies in the same industry, in what is known as relative valuation. It is important to keep in mind that the interpretation of P/E can vary; where some industries have higher than average P/E multiples due to their growth potential, while other sectors may have lower P/E multiples due to the more mature or cyclical nature of their businesses.

What to pay attention to about P/E? There is no absolute conclusion because it is necessary to analyze which of its two components (share price or earnings) is the one that is predominating. However, it is important to make sure that a “high” P/E is based on good fundamentals and not on excessive optimism.  Likewise, attention should be paid to those companies that have a “low” P/E, which could be misleadingly interpreted as an opportunity, when in fact, it reflects a lack of catalysts and little interest among investors.Finally, the P/E multiple can tell us a lot about the general perception that investors have of a share, being a tool that helps to detect opportunities (cheap valuation) or potential risks (expensive valuation). However, before making a conclusion about a company for the purpose of an investment decision, this valuation analysis must be complemented by a thorough understanding of the business model, financial situation, growth strategy and experience of the management team.