Market Outlook and Commentary

June 1, 2023

Market Not Out Of The Woods

John Bonnanzio

Perhaps "the system" works after all.

Of course, I’m referring to the two most visible branches on the federal government, and their somewhat surprising ability to have contained both party’s extremes and hammer out a two-year deal on the debt ceiling and spending.

Regardless of your political compass, Main Street and Wall Street have understood that (and feel free to pick your own poison) a Treasury default, credit downgrade, weaker dollar, bank run and perhaps a global financial crisis were never in anyone’s best interest. Granted, financial markets have been disarmingly quiet these past few weeks. So perhaps I have been in a minority of skeptics!

Be that as it may, and assuming that President Biden signs the marginally bi-partisan budget agreement, what does the removal of this cloud mean for the financial markets?

Unfortunately, there’s still plenty to fret about.

Just around the corner (June 13-14) the Fed will consider an eleventh consecutive rate hike. While the bond market has priced in a "pause," inflation is proving to be pretty resilient. Though knocking it back down from a high of 9.1% last year, this year CPI seems range-bound at around 5%. Moreover, the Fed’s closely watched PCE index (personal-consumption-expenditures) rose more than expected in April (up 0.4%).

Target Fed Funds

There was also a slight year-over-year uptick (to 4.7%) in PCE’s core inflation gauge. That it hasn’t retreated more in the face of a rates rising five percentage points (since March 2022) to a target range of 5.00% to 5.25% is both baffling and concerning. Nonetheless, the argument for a pause is sound. The strongest case is that it takes a long time for higher interest rates to first slow the economy then quell inflation. Some areas are already feeling the effects of higher rates. Among the more apparent is housing and construction.

Substantially higher mortgage interest rates have several effects: they have made home ownership far more expensive while existing homeowners have been reluctant to sell and lose their lower rates. This has exacerbated a housing shortage. Also, the IRS’s shrinking cap gains tax exemption on homes, which isn’t inflation-adjusted, also contributes to low inventory and higher prices.

Among the litany of other concerns: the resurgent dollar’s negative impact on the overseas earnings of mega-cap tech (which are responsible for much of the market’s recent gains); high valuations in tech may lead to profit-taking; China’s economic slowdown and, yes, the U.S. also potentially slipping into recession later this year.

While I’m in the camp that any recession will be both shallow and short-lived, much of that hangs on the Fed’s shoulders. This Friday’s jobs report will be key: If job gains are high (above 200,000), the Fed may respond with another quarter-point rate hike. Though that might be a mistake (the economy still needs time to digest prior hikes), it would certainly be an understandable response.

Fund Commentary
The primary narrative driving a narrow band of stock gauges higher in May was AI euphoria, and on the flip side was the specter of still- higher interest rates coupled with the debt ceiling impasse. Collectively, these were negatives for most stock funds and certainly all bond funds.

Asset-class wise, there was a wide gulf of 10 percentage points between last month’s top- and bottom-tier performers. For example, the Nasdaq Composite Index fund surged 5.9% versus a decline of 4.0% for Real Estate Index. Regardless, there wasn’t a great deal of market angst. Safe harbor gold, for example, retreated only 2% in May while the VIX (volatility index) ended the month pretty much where it began.

Market Indexes
The more economically sensitive (cyclically oriented) Dow Jones Industrial Average retreated 3.2% in May. Its decline was caused mostly by cyclicals (natural resources/energy) and financials (banks). Faring comparatively better (though not great) was the S&P 500 (up 0.4%). And as previously noted, mega-cap tech stocks generally, and Nvidia in particular, powered the Nasdaq Composite up 5.9%. (The index is now trading at its August 2022 level.)

Small–cap stocks fell fractionally last month while mid-caps were down 2.8%. (See chart for year-to-date returns.)

Major Market Indexes

Stock Funds
Overall, Fidelity’s 59 stock funds fell fractionally in May. Large-cap growth offering performed far better than any other group: Blue Chip Growth and Growth Company rose 7.9% and 7.1%, respectively, while OTC (up 5.3%) slightly trailed the Nasdaq. Trend (which is 40% invested in big tech) rose 5.1%.

At the other extreme were value-oriented funds, plus mid- and small-cap offerings. With those combined attributes, Mid Cap Value Index seemed destined to be May’s second-worst performing stock fund: down 4.4%.

Select Funds
Fidelity’s four tech-oriented Selects were last month’s show-stoppers with gains ranging from 6.0% for Tech Hardware to 20.3% for Semiconductors. However, only 11 funds gained ground in May while 23 others retreated. Oil-rich Natural Resources fared worst, down 10.1%, though Gold and Energy (both down 9.4%) didn’t fare much better.

International Funds
Few foreign stock funds rose last month. Seeming to defy gravity, however, is Brazil. Often sensitive to commodity prices, its Bovespa index rose nearly 4% thanks mostly to strong bank earnings. In turn, Latin America fund (up 2.1%) was the group’s best performer. Close by, Japan and Japan Smaller Companies rose 1.7% and 0.3%, respectively. (See Ratings below.)

Overall, international funds were lower in May. Stubbornly high inflation and slow growth are strong headwinds for corporate earnings: International Index retreated 3.9% although Worldwide gained 1.6% thanks mostly to its 64% stake in U.S. stocks and, by the way, its 2.8% weight in Nvidia.

Bond Funds
Bond yields fell sharply at month-end owing to the debt agreement, but were otherwise significantly higher for the month. With the yield curve still inverted, the yield on the 3-month T-bill soared 42 basis points to 5.52%; the benchmark 10-year Treasury yield rose 20 basis points to 3.64%. U.S. Bond Index slumped 1.1% in May, though Conservative Income Bond (a riskier alternative to a money-market) gained 0.4%.  — John Bonnanzio