June 5, 2023
The debt ceiling impasse was resolved this past week. While it was not a surprise that it was resolved, the surprise was it was achieved without a revolt in the financial markets to force a compromise. Investor attention now turns back to the fundamentals (growth, inflation, interest rates, and profits).
The story on the economy over the past two weeks has been hotter job growth, hotter spending, and hotter inflation, which has prompted a reassessment by the markets on the likelihood of Federal Reserve (“Fed”) rate cuts by year-end. Continued strong job and wage gains, combined with excess pandemic-era savings, continue to support resilient consumer spending and inflation. While a number of Fed governors have opined that the recent data doesn’t support a June “pause” in rate hikes as has been widely expected, Federal Reserve Governor and Vice Chairman nominee Philip Jefferson and Philadelphia Federal Reserve President Patrick Harker, seemingly set the stage for a June “skip” with the possibility of future hikes still very much on the table.
The May jobs report this past Friday seemed to support “skip” as it offered a little something for everyone: robust payroll gains (including upward revisions to prior months) and strong non-supervisory wage increases bolstered the hawks, while a decline in household employment, a surprising jump in the unemployment rate, a decline in workweek/hours worked, and moderating overall wage gains boosted the doves. Judging by the favorable stock market reaction on Friday, investors appeared to view this mixed report as a “Goldilocks” scenario.
The lagged effects of the Fed’s massive tightening should cause growth to slow and inflation to cool as we move forward. If (when) the job market weakens sharply, the Fed is unlikely to be in a position to quickly come to the rescue. With a decisive break above 4,200 for the S&P 500, the “Goldilocks”/soft landing narrative has the potential to push the market higher in the near term, at least until evidence of a hard landing emerges and/or declining liquidity (renewed Fed balance sheet reduction/new post-debt ceiling Treasury issuance) removes a prop.
Market gains this year have been powered by an extremely narrow group of mega cap technology stocks, which have been viewed as “defensive plays” and “AI winners”. Such a narrow advance is typically not viewed as a positive for the broader market. However, we may be nearing peak market narrowness, which will need to be resolved either by the rest of the market catching up to the leaders or those leaders pulling back in line with broader market. With mounting recession signals and lessening market liquidity ahead, we would lean towards the latter. Market risk remains elevated in our view with stock valuations full, earnings estimates at risk, investor sentiment complacent, banks restricting credit, and the Fed back to shrinking its balance sheet. Additionally, we have entered the seasonally weak trading period between May and November.