Following the stock market wipeout of 2022, investors entered 2023 hoping for a better year driven by falling inflation and a more dovish Federal Reserve. The first half of 2023 has been just as hectic as 2022, witnessing three of the largest bank collapses in U.S. history, a debt ceiling standoff, and a technological breakthrough with advancements in Artificial Intelligence (AI). Through all of this, the S&P 500 charged ahead nearly 16% to end the first half of 2023, with the majority of returns being driven by a select number of mega-cap technology companies rallying through last year’s wipeout. The narrow market breadth and deteriorating economic data has left many cautious for the second half of the year, with consensus forecasts tentatively indicating a recession at some point in the second half of the year. Inflation has fallen from the peaks of 2022 and the labor market remains strong, but the Federal Reserve has taken a definitively hawkish stance and leading economic indicators (LEIs) continue to show an impending economic slowdown. Nonetheless, the stock market has been resilient to headwinds, with better-than-expected earnings for the first quarter of 2023 and the Bull-Bear spread well above the long-term average, indicating bullish sentiment and upward momentum.
June 2023 Stonemark Market Commentary
Reviewing the First Half of 2023
The May Consumer Price Index (CPI) report was released by the Bureau of Labor Statistics on June 13, which showed headline inflation rising 0.1% in May and 4% year-over-year, both of which were in line with expectations. The latter number was the lowest in almost two years, adding fuel to the optimistic fire that the Federal Reserve’s war on inflation is nearly complete. However, core CPI, which excludes the more volatile food and energy inputs, rose by 0.4% in May and 5.3% on a year-over-year basis, painting a less optimistic picture for inflation. Both CPI numbers were in-line with market expectations, continuing the divergence between headline and core CPI that began in early 2023.
The Core Personal Consumption Expenditures Price Index (PCE) was released on June 30, showing inflation increasing by 0.3% in May and 4.6% year-over-year, 0.1% below market expectations. With Core PCE being the Federal Reserve’s preferred measurement of inflation, the still-increasing number supports the Federal Reserve’s stance of “higher for longer.” While headline CPI is at a two-year low, the less volatile core measurements of inflation are showing stickiness that the Federal Reserve has indicated will require additional action through raising interest rates.
The labor market remains robust, with nonfarm payrolls growing by 339k in May, beating estimates of 190k. The report, released on June 2, showed job gains being led by the healthcare, professional/business services, government, and hospitality + leisure sectors.
Also included in the jobs report was the unemployment rate, which ticked higher to 3.7% versus estimates of 3.5%. The unemployment rate of 3.7% is the highest rate since October 2022, but still relatively low on a historical basis. Average hourly earnings rose by 0.3% in May and 4.3% on a 12-month basis, which was slightly below expectations. However, the continued gains in average hourly earnings have been a sticking point for the Federal Reserve, as increases in earnings correlate with increased consumer spending. Increased consumer spending results in persistent inflation as consumers can continue spending despite price increases. The labor market remains a difficult aspect of the economy to interpret, with continued payroll gains and average hourly earnings growth, despite heavy layoffs at the start the year and a gradually increasing unemployment rate. Seasonal adjustments and revisions to labor numbers have clouded the picture even more, leaving many wondering about the direction ahead.
The Conference Board releases a monthly report that aggregates each leading economic indicator (LEI) for the U.S. economy, which provides important data for economic forecasting. The composite U.S. LEI continued to fall in May, led by deterioration in the gauges of consumer expectations for business conditions, the ISM New Orders Index, a negative yield spread, and worsening credit conditions.
The Conference Board said:
“The US Leading Index has declined in each of the last fourteen months and continues to point to weaker economic activity ahead. Rising interest rates paired with persistent inflation will continue to further dampen economic activity. While we revised our Q2 GDP forecast from negative to slight growth, we project that the US economy will contract over the Q3 2023 to Q1 2024 period. The recession likely will be due to continued tightness in monetary policy and lower government spending.”
The graph showing the YoY percent change in LEI dating back to 2000 would support the Conference Board’s recession forecast, with a steep decline in LEI and near-zero percent real GDP growth, indicating a stagnant economy.
Additionally, the M2 money supply contracted for the 6th straight month on a year-over-year basis, dropping 4% in the month of May. The M2 money supply is a measure of all the cash people have on hand, as well as money deposited in checking accounts, savings accounts, and short-term cash equivalents like certificates of deposit (CDs). A contracting money supply means cash savings are eroding and consumer purchasing power is falling in tandem. GDP in the United States is heavily reliant upon consumer spending, and any cracks in purchasing power will correlate with an economic slowdown.
While M2 continued to decline on a year-over-year basis for the sixth consecutive month, M2 increased on a month-to-month basis. This is important because M2 is a proxy for inflation, meaning when M2 is contracting, inflation usually falls in direct correlation and vice versa. With M2 rising from April to May, this reverses the month-to-month contractionary trend that has been in place since July of 2022. An increase in M2 means the average consumer’s cash balance across a variety of cash and cash equivalent vehicles has risen, affording the consumer stronger purchasing power and potentially correlating with stickier inflation. However, until this trend of M2 growth on a month-over-month basis continues for multiple months, nothing definitive can be drawn. Nonetheless, it is important to note and be watchful of moving forward.
The Federal Reserve Open Markets Committee (FOMC) met from June 13 to June 14, where they unanimously voted to forego a rate hike in June after 11 consecutive interest rate increases at prior meetings. Dubbed a “hawkish pause” by market commentators, the FOMC did not raise hikes whilst simultaneously taking a definitively hawkish stance on future interest rate policy. Chairman Powell explicitly communicated the Committee’s intention to raise interest rates an additional 50 basis points by year end, with some members even wanting 75 basis points by year end. In response to this “hawkish pause,” markets closed the day relatively flat, struggling to find direction with the Federal Reserve pausing but indicating additional rate hikes to come.
The “Dot Plot” is a chart that shows estimates for the Federal Funds Rate, which is the benchmark short-term interest rate controlled by the FOMC. Notably, the median estimate for 2023 is now at 5.6% versus the 5.1% estimate in March. The Federal Reserve has continually indicated that inflation remains well above their target rate and the labor market has remained strong, allowing the Federal Reserve to continue their hawkish positioning until unemployment materially increases or inflation decreases to their 2% target.
The next FOMC meeting is on July 26, where the market is currently pricing a near 90% likelihood of the federal funds rate being raised by 25 basis points to a range of 5.25%-5.50%. This correlates with the FOMC statement released on June 13 that indicated an additional 50 basis points of rate hikes by year end, but the market is currently priced in disagreement with the Fed beyond the July FOMC meeting. While the Fed has indicated 50 additional basis points by year-end, the market is currently pricing 25 basis points in July and a pause throughout the rest of the year. This positioning in the market is anticipating continued cooling in inflation and increased demand from consumer spending. Despite the adage of “don’t fight the Fed,” the market is currently positioned contrarily to hawkish FOMC forecasts.
Bank Stress Tests
The Federal Reserve also released the results of their comprehensive stress testing on the 23 largest U.S. banks, with each bank weathering a severe recession and continuing lending to consumers and corporations throughout. The annual bank stress tests, released on June 28, modeled a hypothetical scenario of a severe recession which would have unemployment at 10%, a 40% decline in commercial real estate prices, and a 38% drop in housing prices.
Each bank tested survived the hypothetical situation, showing strength within the overall banking system. However, there were significant losses in the scenario totaling approximately $541 billion. The largest losses were from credit cards, accounting for 22% of the projected losses. Other substantial losses came from commercial and industrial loans, commercial real estate, and trading and counterparty losses. While the stress tests are hypothetical situations designed to push banks to the extremes, the results are useful in evaluating potential areas of weakness moving forward. Banks and other companies with significant exposure to credit cards and credit card debt are likely to remain at suppressed trading levels until a clear resolution or an improving economic backdrop becomes apparent. Similarly, banks and companies with substantial exposure to commercial real estate and industrial lending will be similarly suppressed.
The stock market has been grappling with a multitude of factors throughout 2023, with bulls finding ground through advancements in artificial intelligence and cooling inflation. The tech-heavy Nasdaq 100 Composite Index, which tends to be more volatile than the broader S&P 500 index, returned over 30% to start the first half of the year. This was the best first half of a year for the Nasdaq since 1983, and the S&P 500 was no slouch, delivering nearly 16% in returns. However, many are cautious to declare victory yet as a murky economic picture looms over the strong stock market performance. Inflation, while cooling, remains persistent and well above the Federal Reserve’s target of 2%. Leading indicators continue to flash warnings for an impending slowdown in the second half of 2023, with the only substantially positive components being year-to-date stock market returns, new housing permits, and the leading credit index. The Federal Reserve has taken a definitively hawkish stance, indicating continued rate hikes beyond their June pause. The result of these contrasting factors on the market is a conflicting message, leaving many struggling to find direction. What remains important, throughout economic slowdowns and expansions, is consistent cash flow and profitability. Companies that retain discipline through good times and bad times, maintain a strong balance sheet, and return value to shareholders are rewarded in the long run. We continue to position our models defensively, favoring companies that are profitable and disciplined while also utilizing ETFs to achieve greater diversification and minimize stock specific risk.