Market Commentary 06/07/23

May presented a mixed picture in the financial markets, as several factors influenced both the credit and equity markets. In the credit market, bond prices experienced a decline amid ongoing debate in Congress regarding the debt ceiling and discussions among investors about Federal Reserve policies. Throughout May, interest rate volatility remained high, making it challenging for investors to navigate. Initially, the 2-year Treasury yield rose by 0.50% but then dropped by 0.20% toward the end of the month following the extension of the debt ceiling. While short-term bonds saw the most significant increase, yields moved higher across the entire curve, posing a clear obstacle for long-duration bonds. However, high yield credit was less affected as credit spreads remained relatively stable.

In the equity market, growth sectors outperformed defensive sectors, continuing the strength of growth-oriented investments. Market breadth remained weak, indicating market gains were concentrated in a few sectors and mega-cap stocks. Sectors such as Technology, Communications Services, and Consumer Discretionary have performed well, while other sectors within the S&P 500 have faced downward pressure in 2023. In fact, the only positive part of the U.S. equity markets year-to-date through May are large cap growth stocks. Every other part of the U.S. equity markets has declined. Not surprisingly, there are concerns about the stretched valuations of growth stocks due to their perceived safe-haven status and the hype surrounding artificial intelligence. If growth stocks falter, it will be crucial for another segment of the market to step forward.

This divergence reflects the current market environment. In the medium to long term, the outlook may be deteriorating as the Federal Reserve’s aggressive interest rate hikes impact the financial system, and economic activity clearly slows down from the immediate post-pandemic levels. Nonetheless, the near-term economic momentum generated by pandemic-era monetary and fiscal policies remains significant, and we have avoided a prolonged recession.

There are two themes to watch as we enter the summer months. First, the resolution of the debt ceiling is positive for the financial system, but there are potential concerns. Raising the debt ceiling allows the Treasury to issue new Treasury securities to replenish its general account, potentially leading to a decrease in liquidity if investors sell stocks or withdraw deposits to purchase these securities. Additionally, the debt ceiling deal reinstates student loan payments this fall, which could impact discretionary spending. The passing of the bill and the subsequent effects on liquidity and consumer finances will be something we closely monitor. Second, the upcoming June Federal Open Market Committee (FOMC) meeting will be important. Our view is that the Fed will maintain higher interest rates until there is clear evidence of easing inflation and unemployment rises above 4% to 4.5%. Market expectations regarding rate hikes have been volatile, and it will be essential to observe if the Fed proceeds with a June rate hike and whether the market aligns with the expectation of rates remaining higher for a longer period.

Overall, our macro-economic view remains mixed. In the near term, we expect rates to remain higher for an extended period. The economy has shown resilience to rate hikes due to pandemic-era backlogs and ongoing economic momentum. However, in the long term, we fear the Fed may be making a policy mistake, potentially leading to a hard landing for the U.S. economy. The balancing act by the Fed remains challenging and we will continue to keep you updated throughout the summer.