June 2023 Market Commentary
July 13, 2023
Drive down a road on a hot summer day and you will invariably see a mirage. And no matter your speed, the mirage remains just out of reach. Since 2022, the specter of a recession, like a mirage, has danced in front of investors; sometimes closer, sometimes farther away. And just like a driver who never actually experiences water on the road, a recession has yet to occur. That remained the case in June as the prospects of a recession appeared to retreat farther into the distance thanks to the Fed’s decision to pause its current interest rate hikes, and generally upbeat economic data.
After raising rates by a cumulative 5% over the course of 10 consecutive meetings from March 2022 through May 2023, the Fed finally paused its current rate hike cycle at its June meeting. Speaking afterwards, Fed Chair Jay Powell explained the rationale, stating “We have raised our policy interest rate by 5%…and the full effects of our tightening have yet to be felt. In light of how far we have come in tightening policy, the uncertain lags with which monetary policy affects the economy, and potential headwinds from credit tightening, today we decided to leave our policy interest rate unchanged.” For investors hoping the Fed’s pause would give way to rate cuts before year end, Powell effectively quashed that notion, saying it would be inappropriate to cut rates until core inflation is “coming down really significantly” which isn’t likely for “a couple of years.” Despite the June pause, markets currently expect the Fed to raise rates once more in July by 0.25%, before holding steady for the remainder of the year. Updated Fed projections, released at the June meeting, indicate two more hikes before year end. Regardless of the actual number, investors appeared heartened by the fact that the Fed’s current rate hike cycle is nearing its end.
In addition to the Fed’s actions, economic data provide an additional tailwind to the markets. First quarter GDP was revised upwards to 2%, doubling the initial 1% estimate. Growth was driven by strong consumer spending which expanded at a 4.2% rate, the fastest pace since 2Q21. Separately, labor market conditions remained decent in June with nonfarm payrolls adding 209K new jobs. While that was the slowest pace since an outright contraction in December 2020, the news boosted market sentiment as the Fed has stated repeatedly that it would like to see labor market conditions cool in order to ease inflationary pressures.
May inflation data reported in June, saw headline consumer inflation slow to 4.0%, the slowest pace since March 2021. Core inflation, which has remained stubbornly high, slowed 0.2% to 5.3%. Continued strong services inflation, buttressed by an 8.0% increase in shelter prices, has prevented core inflation, on which the Fed is primarily focused, from decelerating as rapidly as headline inflation. A recent slowdown in rents is expected to be reflected in official inflation measures during the second half of the year, which could help alleviate pressure on core inflation readings.
The results of the Fed’s annual stress test of 23 large banks provided additional positive news for markets. After the collapse of Silicon Valley Bank in late March, investors became increasingly nervous about the impacts of the Fed’s aggressive rate hikes on the banking sector. Concerns of a recession, and more specifically, a sharp slowdown in the commercial real estate sector further exacerbated those fears. Thus, investors were relieved by the news that all banks covered by the stress test passed. Among other factors, this year’s test assumed a severe global recession with a 40% decline in commercial real estate prices, a substantial increase in office vacancies, and a 38% decline in house prices. In addition, it assumed a rise in unemployment to 10%, accompanied by a commensurate decline in economic output.
Reflecting the overall improvement in investor sentiment, US large cap equities (S&P 500) gained 6.5%, their best month since October 2022. The Dow Jones Transportation index, consisting of 20 transportation companies, jumped 13.3%, its best month since October 2021. Due to its cyclical nature, the index is viewed as a barometer of future economic activity. The strong gains reflected investors’ receding recessionary fears. Corroborating the strength of the Transportation index, small cap equities (Russell 2000) rose 8.0%. Small cap equities, which are generally viewed as being more economically sensitive, benefitted from improved economic sentiment and waning concerns about regional banks. International markets also enjoyed positive returns with developed (MSCI EAFE) and emerging markets (MSCI EM) gaining 4.4% and 3.2%, respectively.
Unlike equity markets, bond markets experienced modest declines with the Bloomberg US Aggregate Bond index, the broadest measure of the US bond market, declining 0.4%. The losses were attributable in part to a steady increase in Treasury yields stemming from the economy’s continued resilience and dissipating fears surrounding the banking sector. Though there has been considerable progress in the battle against inflation, the Fed remains unhappy with the pace. As a result, multiple Fed members touted the need for additional rate hikes, despite keeping rates steady at their June meeting. As the month progressed, the market began to accept the increasing probability that the Fed will follow through with their guidance. The 2-year Treasury yield, whose movements are more influenced by Fed action, rose 0.49%, closing the month at 4.90%, 0.17% below its year high of 5.07%, after falling as much as 1.30% in the aftermath of the bank failures. The 10-year Treasury yield, which is more heavily influenced by investor’s future expectations for inflation and broader economic activity, rose 0.19% to 3.84%, 0.22% from its year high recorded in March and up 0.53% from its post-bank failure low. Though not fully recovered, June was a month where the markets realigned with Fed guidance which indicates more hikes ahead and no rate cuts until sometime in 2024.
Though higher yields were the norm across the Treasury curve in June, municipal bond yields fell slightly across the curve. June and July are heavy municipal reinvestment months which spur strong demand. Combined with a shortage of supply, the result was higher prices which kept yields constrained. Treasury yields typically exert a strong influence on the direction of the municipal bond market, but this was a unique month where circumstances dictated a temporary divergence.
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