May 2023 Stonemark Market Commentary

In the early hours of the morning on Monday, May 1, the second largest bank collapse in U.S. history occurred, with regulators taking First Republic Bank (FRC) into receivership and subsequently selling the failed bank to JPMorgan Chase & Co (JPM). Despite FRC being the third major bank collapse in under two months, the Federal Open Markets Committee (FOMC) continued their fight against inflation, raising the federal funds rate by an additional 25 basis points on May 3. Despite these headwinds, the tech-focused Nasdaq Composite index returned over 8% in May, with standouts like Nvidia returning over 30% in May, driven by artificial intelligence optimism. This surge in mega-cap technology companies has driven much of the S&P 500’s year-to-date returns, accounting for over 80% of the S&P 500’s return.

Nvidia provides a clear definition of what A.I. is at its simplest form: “the capability of a computer program or a machine to think and learn and take actions without being explicitly encoded with commands.” A.I. bears similarities to previous technological breakthroughs like the printing press, electricity, and the internet with the main defining characteristic being an exponential boom in productivity and efficiency across industries. Optimism and hype surrounding artificial intelligence came to a peak on Thursday, May 25 following Nvidia’s earnings report, which greatly exceeded analysts’ expectations for the quarter, and their next quarter guidance blew out expectations. NVDA was expected to guide approximately $7 billion in revenue for Quarter 2 of fiscal year 2024, but instead guided for revenues of $11 billion for Quarter 2, a surprise of almost 60% to the upside. The market responded with vigor, causing NVDA shares to surge by nearly 25% and adding approximately $200 billion in market capitalization in a single day. While NVDA has been the standout performer year-to-date, with shares up nearly 170%, other companies with presence in the artificial intelligence industry have been stellar performers as well.

With such enthusiasm in the market about artificial intelligence, many are wondering if A.I. is truly material or just another market fad, akin to the NFT and metaverse crazes of 2021. Artificial intelligence is material and something that will radically change the global economic landscape. Microsoft’s ChatGPT, unveiled earlier in the year, is actively being incorporated into Windows operating systems across hundreds of thousands of personal computers, with a myriad of capabilities that will boost efficiency in years ahead. Alphabet’s Bard is another “A.I. companion” designed to boost productivity and can actively produce more streamlined and accurate search results in their market-dominating Google search engine. Nvidia’s A100 and H100 server chips are being used in datacenters across the world to accelerate compute capability for machine learning farms necessary to build the large language models that drive these artificial intelligence programs.

However, artificial intelligence is not something that is particularly new, as companies have been developing A.I. for over a decade now, and it is still a technology in its infant years. As the market rewards companies that are apparent leaders in the A.I. race and punishes companies that are laggards in the A.I. race, it is important not to get swept into the hype and potential fear-of-missing-out (FOMO) that so many fall victim to when exciting technology emerges. This is not to say that one should fade this A.I. rally; we think exposure to the sector is warranted and even necessary, but investors should approach with caution and a rational thought process as with any investment.

The sheer extent and capability of artificial intelligence remains an unknown, and it is likely that this will remain the case for many years. Despite A.I. still being a young technology, Microsoft’s ChatGPT-4 is already outperforming humans across the board in various academic exams, as seen below. Numerous industries stand threatened by the potential of A.I. to replace them, particularly in fields like quantitative analytics, web/graphic designers, and data handlers. As such, the potential of A.I. is truly an unknown, meaning that forecasting involves numerous assumptions with small amounts of historical data as a basis.

Companies like Nvidia and AMD boast exceptionally bullish valuations on the potential of A.I., while the rest of the market reflects a more bearish outlook due to the macroeconomic environment. A significant divergence in performance has developed, with the mega-cap technology sector driving over 80% of the S&P 500’s year-to-date return and the remaining 70% of companies being essentially flat on the year. In price terms, 228 of the S&P 500 companies are positive on the year, versus 275 that are negative on the year. Of the 228 that are positive, there is a significant outperformance in a concentrated group of technology companies that is largely driven through A.I. optimism. This narrow market leadership is reason to be cautious of market performance year-to-date and shows relative weakness on a macro-view of the market. High concentration in market leadership is indicative of higher risk in the market, with the top performers bearing expensive valuations and the rest of the market facing continued economic headwinds.

The Bureau of Labor Statistics released the Consumer Price Index (CPI) report for April on May 10, which showed headline CPI rising 0.4% in April and 4.9% on a year-over-year basis, which was slightly below estimates. Core CPI, which excludes the more volatile food and energy inputs, rose 0.4% in April and 5.5% on a year-over-year basis, showing an inversion between headline and core CPI that began earlier in 2023.

Inflation is slowing and the year-over-year numbers for headline and core CPI are falling, but it is remaining present at elevated levels across all measures. The Core Personal Consumption Expenditures Price Index (PCE) was released by the Commerce Department on May 26, rising 0.4% in April and 4.7% year-over-year, both above market expectations. Core PCE has been the preferred measurement of inflation for the Federal Reserve, and April’s report being hotter than expected signaled to the market potential for an additional rate hike in June.

Additionally, the labor market in America remains robust despite other aspects of the greater economy showing continued weakness. Released on May 5, the jobs report reversed the trend of declining job gains month-over-month, with nonfarm payrolls growing by 253k in April, substantially above estimates of 180k.

Unemployment also ticked lower to 3.4% versus market expectations of 3.6%, with the unemployment rate now tied for the lowest level since 1969. Average hourly earnings grew by 0.5% in April, with a 12-month increase of 4.4%, both above expectations. The Federal Reserve has watched the labor market closely throughout its fight against inflation, arguing that a continually robust labor market will hold inflation at elevated levels due to employment buoying consumption and household spending. The Federal Reserve bears no direct control over the labor market and inflation remains sticky. As such, the persistently high inflation measures coupled with the hot employment and labor numbers mean the Federal Reserve is likely to maintain interest rates at current levels and potentially even raise rates again by 25 basis points in June.

The Federal Open Markets Committee (FOMC) met for the first time since mid-March on May 2 and 3 to determine appropriate action to return inflation to its 2% goal and ensure price stability. Despite another bank collapse and continued cracks showing up due to the rapid increase in interest rates, the Federal Reserve unanimously voted to raise the federal funds rate by 25 basis points to a range of 5-5.25%.

The market’s reaction to Fed Chair Powell’s commentary was mixed, with initial reactions interpreting the FOMC meeting as a “dovish hike.” This “dovish hike” was meant to be a subtle indication from the Federal Reserve of a pause after the May rate hike. This was supported by the removal of the verbiage “the Committee anticipates that some additional policy firming may be appropriate” from the post-meeting statement. However, Chair Powell stated in the meeting that there remains work to be done in the fight against inflation, with current levels substantially above the Federal Reserve’s 2% target. Current market expectations for the June 14 meeting sit at a near 75% chance of a pause.

The Federal Reserve also released the Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices on May 8. This report covers the changes in lending standards and demand for bank loans to businesses and households for the past 3 months. The key takeaway from the April report was that banks were continuing to tighten lending standards across the board, particularly in Commercial Real Estate (CRE), and that demand for commercial and industrial loans was down substantially.

The effect of the Federal Reserve switching from quantitative easing (QE) to quantitative tightening (QT) on loans in the commercial space is shown directly in the sharp uptick in late 2021 through to current day.

Continued stress in the CRE market from the continued rate increases over the past 15 months and weak demand due to sustained work-from-home and hybrid work formats is showing up in the extensive tightening of CRE lending standards.

Coinciding with tightening standards for commercial and industrial loans, as well as CRE loans, demand for each has fallen substantially. This is indicative of slowing economic activity and potential entry into a period of contraction.

We discussed the debt ceiling in detail in our April 2023 Market Update, but developments have occurred since that was released as the country approaches the X-date of June 5. House Speaker McCarthy and the Biden Administration arrived at a tentative deal that would suspend the debt ceiling until 2025, keep non-defense spending flat in 2024 with a 1% increase in 2025, increase defense spending by 3% this year, return unused Covid funds, cut $20B of recently passed IRS funding, and resume student loan repayments in August of 2023. The bill made it through the House on the night of May 31 and is now waiting to make it through the Senate. Snags in the Senate are likely to occur, but the bill is expected to make it through the Senate before the X-date and be signed by President Biden, effectively resolving the debt ceiling debacle that has weighed on the market for over a month now.

The bifurcation between “tech and the rest” has left the market seemingly split in an uneven fashion. Spurred by artificial intelligence, many technology companies are exciting and delivering substantially outsized returns, driving most of the overall index’s year-to-date return. On the other side, the rest of the market is effectively stagnant, with some sectors like communications and consumer discretionary posting decent returns and others like financials and energy underperforming, leaving the “rest” flat on the year. Despite this A.I. boom, the macroeconomic problems we were facing throughout 2022 persist into the current day and pose significant headwinds to near-term market performance. Inflation remains well above the Federal Reserve’s target, labor continues to be robust, and lending is tightening across the board. Amalgamated together, the forecast is a slowdown in the second half of 2023 and potentially into 2024, and interest rates are likely to remain at current levels or higher through the end of the year. We will continue to look for opportunities in the market, favoring companies that will be resilient through an economic slowdown and maintaining discipline through volatility ahead.