Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research

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The Quick Facts

• Equity markets rally, though breadth is narrow
• The Nasdaq rallies 7.7% in May and posts its longest monthly winning streak since December 2021
• Artificial Intelligence (AI) and its growth potential dominated headlines
• Earnings estimates are starting to trend higher
• Inflation continues to moderate
• The Federal Reserve (“Fed”) is seen sticking with rate “skip”
• Senate passes bill on the debt ceiling, a U.S. default is avoided

Uncertainty reigned across U.S. markets in May. Grappling with persistent inflation, investors struggled to anticipate the Fed’s rate hike trajectory and the outcome of the federal debt ceiling debates.

Amidst these concerns, strong earnings in a handful of sectors helped buoy equities, yet worries over a May 31 House of Representatives vote on the debt ceiling deal ultimately weighed on markets.

Fueled by the strength of mega-caps, the S&P 500 posted a gain of 0.4% in May. The Nasdaq 100 Index, which is heavily weighted in the tech space, gained 7.7% in May, rose 30.8% YTD and made a new 52-week high this month. In contrast, the Dow is flat for the year. Seven of the top eight stocks in the S&P 500 by market capitalization are primarily responsible for all the 2023 gains, which makes investors cautious about market breadth and narrow leadership.

With the reporting season wrapping up, the bottom line is S&P 500 earnings came in better than significantly lowered expectations. The annual estimates for both calendar 2023 and 2024 are now beginning to trend higher, but whether this is a durable increase has yet to be confirmed. 2023 earnings estimate of $220 would be roughly flat earnings growth for the year, and $246 for 2024 would be a 12% growth rate. This translates into a 2024 PE for the S&P 500 of 17.0x.

May Asset Class Performance

On a total return basis, Information Technology and Communication Services were the best-performing sectors for the month, both up 8.9% and 3.9%, respectively, while Energy showed the largest decline, falling 10.0%. Despite volatility in the banking sector that led to a sharp selloff at the start of the month, regional banks rallied as the fear of contagion dissipated into the month-end. The financial sector was down 4.3% for May and 6.7% YTD, the third worst sector performance YTD, behind energy (-11.5% YTD) and Utilities (-7.2%).

Large-cap Growth stocks outperformed Value stocks by a staggering 8.4% for the month, with the Russell 1000 Growth index now outperforming the Russell 1000 Value index by 22.2% YTD. The ESG segment of the market, as measured by the MSCI USA ESG Select Index, was down 0.4% in May, 0.8% worse than the S&P 500. Over the last three years, the ESG index is up 41.4% and 3.3% behind the S&P 500 on a total return basis.

The Fed unanimously voted to hike rates by 25 basis points at the May 3 meeting, bringing the overnight rate to 5.00%-5.25%. During the ensuing press conference, Fed Chair Powell said the Federal Open Market Committee (FOMC) might be inclined to pause future rate hikes and was not thinking of cutting rates anytime soon. This stood in contrast to the Fed funds futures market pricing rate cuts before the end of the year. The tightening of credit conditions induced by the regional banking crisis complicates the task of achieving a restrictive stance. The May FOMC meeting minutes showed that officials were split on a decision for further hikes. Fed fund futures are now pricing in only a one in three chance of a 25 basis-points hike at the June 14 meeting.

Inflation continues to moderate. April’s Consumer Price Index (CPI) print at 4.9% was down from the June 2022 peak of 9.1%. While still elevated and far from the Fed’s 2% target rate, it is tracking in the right direction. April’s headline CPI was in-line with expectations at +0.4% M/M. Core-CPI, which excludes food and energy, was also up 0.4% M/M, in-line with consensus. The continued moderation in inflation should help temper the Fed to keep its policy rate unchanged when it meets again in June. The Producer Price Index (PPI) also continued to moderate last month.

Treasuries finished May with gains across the curve. The yield on the benchmark U.S. 10-year Treasury now stands at 3.64% compared to 3.42% at the end of April. Shorter term 2-year U.S. Treasury rallied into month-end and now yields 4.40%. The yield curve remains inverted, with the U.S. 2-year Treasuries yielding 76 basis points more than 10-year maturities as compared to a 55 basis-point inversion at the beginning of the year.

Oil futures fell to multi-week lows on concerns over weakening demand and a stronger dollar. Oil prices, as measured by the WTI Crude Oil, were down 11.3% in May to $68/bbl. WTI traded as high as $123.70 back in March 2022, a 14-year high. Gold spot prices broke out to new highs on May 5 at $2050/Oz before closing 1.4% lower for the month at $1,963/Oz. Cryptocurrencies were a mixed bag. Bitcoin was down 7.6% in May while Ethereum was only down 1.4%, bringing their YTD total returns to 64.0% and 55.6%, respectively. The U.S. Dollar Index (DXY) gained 2.6% in May on the expectation that the Fed will continue to hike rates as inflation remains too high. YTD, the U.S. Dollar Index is now up by 0.8%.

Interest rate volatility has been constant since the Fed began its rate-hiking cycle last year. While equity investors look to the CBOE Volatility Index (or VIX), bond investors focus on the ICE BofA MOVE (MOVE) Index, which measures bond market volatility. The MOVE Index remains elevated compared to historical averages, which reflects the highly uncertain rate environment. The VIX, on the other hand, is trading at historically low levels, closing May at 17.9. Even with the uncertainty about the debt ceiling during May, the VIX traded in a narrow range between 15 and 20.

Chart of the Month – Debt Ceiling

The debt ceiling is a legal limit on the total amount of debt that the U.S. government can accumulate to finance its operations. It is a cap set by Congress on the amount of money the government can borrow to meet its existing obligations, such as paying for government programs, servicing existing debts, and issuing tax refunds. When the government spends more money than it collects in revenue, it covers the shortfall by issuing Treasury bonds and other forms of debt. The debt ceiling determines the maximum amount of debt the government can issue. If the debt reaches the established limit, the government must take measures to avoid defaulting on its obligations.

The debt ceiling has been raised 78 times since 1960. Raising the debt ceiling used to be a rubber-stamp affair. Not so when you have divided government. Failing to raise the debt ceiling could lead to severe consequences, including a potential default on the government’s debt, which could have a significant impact on financial markets and the overall economy.

It is important to note that the debt ceiling is a contentious political issue, and debates often arise when it comes time to raise or suspend the limit. Different political parties and policymakers have differing opinions on the appropriate level of government borrowing and how it should be managed. The debt ceiling does not limit spending; it limits the government’s ability to fund already approved spending.

As we go to print and after weeks of political impasse, tense negotiations, and mounting economic anxiety, the Senate gave final approval on June 1 to bipartisan legislation, suspending the debt limit and imposing new spending caps, ending the possibility of a calamitous government default. The U.S. faces an ongoing budget and federal debt crisis – it is this issue, not the debt ceiling, that should be the focus of policymakers.

Quote of the Month

“The principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.” ― Thomas Jefferson

Major Asset Class Dashboard

RELATED LINKS

Macro & Markets: An Update from the CIO May 2023

Beacon ‘Pointe of View’ – A Market Update May 2023

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