As of market close May 26, 2023. Returns in percent.

 Investment Insights

 — Steve Orr 

Last chance

Well, we would like to go on record as saying that May has been “interesting.” Earnings season for the first quarter came off better than expected. The revisions to first quarter’s GDP estimate showed growth of 1.3%, exactly half of the growth rate in 2022’s fourth quarter. Perhaps it is not apparent in your day-to-day activities, but the slowdown is upon us. The final days of the month were consumed with unnecessary hype about the debt ceiling. 

Good news balanced with bad news should help stocks just stumble along, and for the most part, they did. Making the final entries in the May performance ledger, the S&P 500 is up a nice 1%, Mid down -1.8% and Small Cap flat. Emerging markets continue to be weighed down by China’s reopening and real estate problems. The MSCI EM index is currently hovering around unchanged levels for the month. 

May’s rock star award goes to mega-cap tech, with a special hero award to Nvidia. The video chip producer is riding the artificial intelligence mania. Last Thursday’s excellent earnings report pushed the stock to a one-day gain of 24%. Tuesday morning’s trading saw the share price briefly touch $419, pulling the market capitalization over $1 trillion. If you still perform valuation metrics on individual stocks, we note that share price is more than 40 times Nvidia’s sales. 

If tech is the leader, then who is bringing up the rear? Just who you would not expect. In times of uncertainty, defensives should lead the way. Utilities, materials, and financials and health care are all in the red year-to-date. Energy was last year’s winner, posting a +64% gain. This year, burdened by abundant supply thanks to a slowing global economy, energy is the S&P 500 caboose, falling -9% through last Friday. 

Urge to diverge

The S&P 500 tech sector is up 32% this year, far away from Small Cap’s -0.3% return. That is an amazing and rare divergence. When was the last time tech ran away from the rest of the market? That would be the 1999 dot.com run into the 2000 tech bust. What else was going on then? The Fed was raising rates to a peak of 6.5% and the debt ceiling was in the news. History does not repeat, but according to Mark Twain, it does rhyme.

Our Bull friends point to the fact that since World War II, the S&P 500 has had a number of cases where it fell into a Bear cycle, hit the low (last October) and then took months to climb out. Looking at the seventh month since the last low, Bespoke Research found that the S&P 500 was higher three and six months later in all but one case. And of course, that one case was 2001 into 2002, after the dot.com bust. 

Each month removed from last October moves us closer to unwinding the Bear cycle. The cheery economists keep pointing out that every forward-looking data point is flashing red for the economy. Who is right? Mr. Market today or the economy tomorrow? Is it possible for stocks to lead us through the economic needle to a soft landing in the second half of the year? We think it’s possible but very long odds of happening. The best fork in the road right now is a mild slowdown with rolling layoffs that render unemployment and inflation near 4% by the end of this year.

Rate rise

Rates rose in the back half of the month as traders realized two facts: 1) inflation is not going away anytime soon, and 2) the Fed is serious about inflation. Most year-over-year inflation measures calculate the annual change by subtracting the same month change from the prior year. Thus, recent comparisons showed relative improvement over last year’s gasoline price spikes. The next couple of months should show similar improvement. In fact, we could see a break below 4% briefly in the next couple of months. But alas, the inflation battle is not won. 

Short-term rates are in restrictive territory, but services and wage inflation will push inflation back into the high 4s by the fall. Recent statements by Barkin, Mester and Waller show the Committee thinks inflation is too high. Markets stomped their feet and wanted the Fed to pause but are coming around to the idea that the Fed may raise  in the next meeting or two. May consumer prices are released on June 13 and the Fed issues its press release on June 14. We believe the Fed could “pause” at the June meeting, being so close to the debt negotiation and the CPI release. They then could make a case for raising in July. 

This Friday’s job report will keep pressure on the Fed to raise rates. Analysts expect May’s initial jobs report to show gains of at least 190,000 and an unemployment rate of 3.5%. No recession in the middle of the second quarter. 

Bond traders have inflation and a coming wave of supply to manage. When new stock is coming to your shelves, what do you do? Have a sale to clear out the old stuff. Bond prices have fallen nine of the last 12 trading days. The yield on the 10-year Treasury has risen 17 basis points this month to 3.69%. The broad Bloomberg US Aggregate index is down over -2%  this month as a result. Some pundits put the higher yields at the feet of Congress with worries over the debt ceiling. No, history says rates drop, as traders mark Treasury bonds higher in a flight-to-safety trade during debt negotiations. No flight to safety here. 

Two points: A number of corporate bond issuers (Apple for one) came to market in advance of the rate rise. Selling Treasurys is an easy hedge. They also know that Secretary Yellen has pushed over $500 billion out into the banking system from the Treasury’s checking account to pay bills instead of issuing debt. Money into the banking system helps markets, especially big tech. Coming your way courtesy of Congress: When the debt bill is signed into law, the Treasury will issue an estimated $900 billion in new debt. That will load up dealer inventories (their “product shelves”) and pull money back out of the banking system. Tech reversal anyone? 

Industrial dis-ease

Texas shares the same problem with the rest of the U.S. when it comes to manufacturing. Still too much inventory, shrinking order books and a lack of trained workers are the order of the day. The most recent Dallas Fed survey showed factory activity remained flat in May. New orders fell for the twelfth month. Executives’ perceptions of business activity fell to three-year lows. The general business activity index registered a -29 reading. Prior drops below zero marked the start of recessions. These readings also closely match the Kansas City and Richmond Fed surveys. True industrial production no longer dominates the economy — consumer spending is around two-thirds of GDP. But — the manufacturing folks are generally higher paid and make stuff for the rest of the economy. 

Not done

Warm but not done yet. McCarthy and Biden have a deal in principle, but the debt ceiling does not change until the President’s signature is on the bill. This six-month ordeal may last into the weekend. 

As of this writing, the bill raises the debt ceiling through January 1, 2025, conveniently just after the Presidential election. The amount is projected to be between $3.5 and $4 trillion. There are mild spending cuts and freezes on some programs. The Republicans originally asked for $300 billion in spending cuts. As of Tuesday morning, that figure was down to $200 billion. We know those cuts are actually just reductions in the rate of increase, but less is better than none when it comes to increasing the Federal debt. We will refrain from more details until something gets to the Senate. For now, just knowing that the fringe elements in both parties are mad is a good sign.