Equity market completes stunning roundtrip

Bottom line

Any equity investors who took an off-the-grid sabbatical on Feb. 19, when the S&P 500 was at a record high of 6,147, and returned today might not think anything of its intra-day record of 6,187. So, nothing much happened over the past four-plus months, right? 

No, not unless you count stocks experiencing one of the most volatile periods in history in between. The VIX index spiked from 14 in mid-February to 60 when President Trump’s trade and tariff policy unfolded, but it has since declined to 16. 

Equities followed suit After plunging 21% from mid-February to April 7 due to the botched roll out of the tariff policy, the S&P 500 has surged more than 27% over the past three months, recovering all the ground lost in the post-Liberation Day waterfall decline. The drop and bounce in the tech-heavy Nasdaq Composite was even more extreme, with a 27% drop fully erased by its subsequent 37% rally. Federated Hermes increased its stock overweight by 5% in early April, affirmed our 6,500 year-end target for the S&P and recently increased our target price for 2026 from 7,000 to 7,500. 

Benchmark 10-year Treasury yields shot up from 3.9% in early April to a mid-May peak of 4.6%. But bonds have since rallied back to a 4.27% yield amid a flight-to-safety trade. Our duration team remains in its long position of 102.5. 

Are investors ignoring the risks? Six weeks ago, Moody’s belatedly followed in the footsteps of S&P Global and Fitch by downgrading US sovereign debt. As it was anticipated, it was a lagging indicator of what markets and policymakers already know: The fiscal trajectory of the federal government is unsustainable, and political dysfunction continues to hinder meaningful reform. The rating agencies are simply recalibrating expectations to underscore their growing concern about the credibility of US fiscal policy. 

• S&P Global sounded the first alarm The initial domino to fall was S&P Global on August 5, 2011, just three days after the passage of President Obama’s Budget Control Act (BCA) of 2011, which raised the debt ceiling by $400 billion and mandated $917 billion in discretionary spending cuts over 10 years. Despite these favorable measures, S&P downgraded the US from AAA to AA+, citing the rising public debt burden and persistent policymaking uncertainty. In their view, the inability of both political parties to reach consensus on a credible fiscal consolidation plan, combined with the use of the debt ceiling as a political bargaining chip, undermined confidence. S&P was particularly critical of the BCA’s failure to include any new revenue measures. 
• Fitch followed suit On August 1 2023, following the passage of the Fiscal Responsibility Act (FRA), Fitch downgraded the US credit rating from AAA to AA+ with a Stable Outlook. It cited two primary reasons: the high-and-growing government debt and erosion of governance relative to other peers. In Fitch’s view, the federal government’s fiscal and debt management standards had deteriorated over the previous two decades, exacerbated by repeated political standoffs over the debt ceiling. The agency pointed to a decade of tax cuts and elevated spending as key contributors to the rising debt burden. With interest rates climbing, the cost of servicing that debt increased, raising concerns about the government’s growing reliance on borrowing to meet its obligations. The agency also flagged the looming expiration of the 2017 tax cuts in 2025, projecting that their extension would significantly widen the deficit. 
• Moody’s makes it a clean sweep Moody’s justified its US rating downgrade from Aaa to Aa1 on May 16 by citing deteriorating governance, persistent fiscal deficits and elevated spending without revenue increases. The rapid rise in government debt amid higher interest rates is also deeply concerning to the agency. The cost of servicing the debt was $954 billion in fiscal year 2024, more than the mammoth amount spent on defense or Medicare. Without a course correction, the Congressional Budget Office (CBO) projects debt service will approximate $1.7 trillion in 10 years. 
• Double-edged sword Moody’s warned that extending the 2017 Tax Cuts and Jobs Act beyond its scheduled expiration at the end of 2025 could add an estimated $4 trillion to the deficit over the next decade. But if Congress lets the law expire, the resulting tax increase of $4.5 trillion could push the economy into recession. 
• Common thread All three rating agencies emphasize tax cuts and the government’s inability to raise sufficient revenue to match rising spending. But the US does not have a revenue problem, as federal tax revenue as a percentage of GDP is at 17% now, in line with its 65-year average. Federal spending as a percentage of GDP, however, has averaged 20% over the past 65 years, which means we have an imbedded 3% federal budget deficit on average over this period. At present, spending is at 24% of GDP, due to elevated federal spending over the past four years, resulting in a 7% federal budget deficit. Treasury Secretary Scott Bessent hopes to gradually reduce the deficit back to 3% by 2028. 

Keynesian and supply side tug-of-war Raising tax rates, particularly on high earners, to fix the spending problem, risks reducing both revenue generation and economic growth. According to 2022 IRS data, the top 10% of US wage earners already pay 72% of federal income taxes, while the bottom half collectively pays 3%. Moody’s says the top 10% of taxpayers also account for half of all consumer spending, which accounts for 70% of GDP growth. Taxing this group could impede their ability to save, invest and consume, which in turn could impair economic growth and financial market performance.

Need to reduce spending The federal debt has ballooned from $6 trillion at the end of President Clinton’s term in 2000 to $36 trillion under President Biden in 2024, That makes for a compound annual growth rate (CAGR) of 7.8%. But current-dollar GDP over this period has grown at a CAGR of only 4.5%. So, to correct this unsustainable trajectory, Congress needs to grow the economy faster and reduce the growth of federal spending. Targeted reforms that address the waste, fraud, abuse, mismanagement and inefficiencies of current spending commitments are a reasonable first step. 

Financial mileposts We see possible storm clouds on the horizon for investors:

• One Big Beautiful Bill Congressional sausage-making is happening in the Senate after narrowly passing the House. Trump wants to sign the bill into law on Independence Day, but July 4 may be an aspirational target.
• Trade and tariff deadline The 90-day negotiation period expires on July 9, but could be extended again.
• Second-quarter revenue and earnings The reporting season kicks off July 15, with expected EPS growth of about 5% year-over-year roughly half that of the first quarter.
• Fed policy The next FOMC meeting is July 30, with two members of the Board of Governors (Chris Waller and Michelle Bowman) suggesting it could be in play for a rate cut. 
• Debt ceiling Bessent has said the X-date for the federal government running out of money will arrive in mid-August.
• Jackson Hole The Fed’s annual monetary policy symposium takes place August 21-23 in Wyoming; a deep dive into labor market strength is expected.

Research assistance provided by Federated Hermes summer intern Devin Clancy.

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