May 2023 Market Commentary
June 15, 2023
Déjà vu, which in French means “already seen” is defined by the Merriam-Webster dictionary as “a feeling that one has seen or heard something before.” Investors would certainly be forgiven for feeling a sense of déjà vu in May, as they watched what has become the time-honored tradition of politicians in Washington haggle over the debt ceiling. For years, raising the debt ceiling was done with little fanfare. By some measures the ceiling has been lifted 80 times since 1960. However, over the past 15-20 years, raising the debt ceiling has become increasingly contentious. Under this new paradigm, both political parties issuing dire warnings about the ramifications of a government default, declare that they won’t let one happen, blame the other side for not cooperating, eventually strike a deal to raise the debt ceiling, and then explain to their respective constituents how they “won”.
In May, that is exactly how events surrounding the need to raise the debt ceiling unfolded. As a result, equity markets remained relatively sanguine, confident that they had already seen this movie before and that despite all the ominous warnings, a default would be avoided. The same could not be said, however, for the fixed income markets where, for a time, investors showed more palpable concerns. That was best reflected in the 30-Day T-Bill yield which briefly surpassed 5.7%, a level not seen since its inception in 2001, driven by concerns of at least a short-term government default during which bond holders might not be repaid on time. However, as it became clear a default would be avoided those yields retreated closer to 5.0%.
Beyond the debt ceiling markets remained focused, on inflation readings and the implications thereof for future Fed monetary policy actions. Inflation data reported in May saw the headline consumer price index (CPI) inflation slow on a year-over-year basis from 5.0% to 4.9%, not a huge decline, but progress, nonetheless. Shelter was the largest contributor, followed by used cars and trucks, and gasoline. Core CPI inflation, excluding more volatile food and energy prices, slowed from 5.6% to 5.5% but remained stubbornly high in part due to a 6.8% increase in services pricing. Expectations remain that both headline and core CPI will slow further in the second half of the year as a recent slowdown in rent growth is reflected in the data. With respect to the Fed, recent comments by various Fed officials, including Chair Powell, suggest they will hold rates steady at their June meeting. Speaking at a conference in mid-May, Powell stated that “Having come this far, we can afford to look at the data and the evolving outlook and make careful assessments.” Should the Fed in fact forgo a rate hike in June, it would mark the first pause in the current tightening cycle since its inception in March 2022, providing officials with additional time to assess the cumulative economic impact of their inflation-fighting efforts. Current market expectations are for the Fed to conduct one additional 0.25% increase in July before commencing rate cuts in November with a 0.25% reduction.
Another focal point for investors in May was first quarter corporate earnings reports which provided investors with a gauge on the health of the economy. Compared to a year ago, consolidated S&P 500 earnings declined nearly 6.5%, marking the second consecutive quarterly decline, and largest absolute decline since 2Q20, when earnings fell nearly 32%. First quarter’s decline was the result of slowing demand and surging expenses which resulted in net profit margins falling from 12.3% to 11.5%. Earnings are expected to contract once more in 2Q23, before staging a rebound in the second half of the year. However, those forecasts could prove to be overly optimistic should economic growth slow further.
Economic data released in May continued to point to mixed conditions. According to the Institute for Supply Management (ISM), manufacturing activity contracted for a 6th consecutive month, while service sector activity expanded, albeit at a relatively modest pace. Within housing, existing home sales fell for the 2nd consecutive month, while new home sales jumped to their highest level in 13 months. Even employment, which has remained relatively robust over the past year, was not immune to conflicting data. Nonfarm payrolls added 339K jobs in May, well above the forecasted 195K jobs, and the fastest pace since January. However, despite the strong headline number, unemployment rose 0.3% to 3.7%, the highest level in seven months. Part of the disconnect can be attributed to the fact that the data used to calculate the unemployment rate comes from what is known as Household Survey data, whereas changes in nonfarm payrolls are calculated from Establishment Survey data. For May, according to the Household Survey data, unemployed persons rose 440K, the combination of 310K individuals losing jobs while an additional 130K entered the labor force but failed to find work. Separately, job openings data reported for April increased by 258K to 10.1M, ending three straight monthly declines in job vacancies, and suggested that demand for labor remains robust despite recession concerns.
As a result of the market’s overall wait-and-see attitude regarding the debt ceiling, banking turmoil, and future Fed policy decisions, domestic returns were relatively muted, with large caps (S&P 500) gaining just 0.3%, while small caps (Russell 2000) fell 1.1%, weighed down by greater exposure to smaller banks. International markets fared worse during the month with developed (MSCI EAFE) and emerging (MSIC EM) falling 4.8% and 1.1%, respectively.
In the Treasury market, yields trended higher during the month, resulting in the Bloomberg US Aggregate Bond Index, the broadest measure of the US fixed income market, falling 1.1%. The largest driver of the higher rates was the continued normalization of monetary policy expectations following the banking troubles from early March. In the immediate aftermath of Silicon Valley Bank’s collapse, markets assumed rapid rate cuts from the Federal Reserve would be forthcoming. Concerns about regional banks persisted at the start of May as First Republic Bank collapsed, leading to its seizure by bank regulators and subsequent sale to JP Morgan. However, as the month progressed without any additional failures, expectations for rate cuts, slowly receded. The result was a protracted rebound in yields. From pre-banking crisis levels of 5.07% on the 2-year Treasury and 3.99% on the 10-year Treasury, yields fell as much as 130 basis points and 68 basis points, respectively. By the end of May, about half of the declines had been erased. The fuel for the recovery came in two forms: 1) Federal Reserve messaging that suggested that not only will there be no cuts in 2023, but the next move is likely another rate increase, possibly at the upcoming June meeting but more likely in July; and 2) the debt-ceiling negotiations, which led to rising yields on the prospect of a technical U.S. default. With a negotiated debt deal in place, yields fell a bit in the final days of the month. The focus now returns to the Fed and its continued battle with inflation, which remains stubbornly high.
Municipal bonds followed a trajectory, similar to that of Treasuries over the course of the month, reaching new 2023 highs in yields before dropping a bit on the debt-ceiling agreement to end the month. Yields will now be pressured upwards on anticipated Fed action, but mid-year is also a very heavy reinvestment period in the municipal markets. That increased demand should help keep prices in line and counteract some of the Fed’s potential aggressiveness.
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