Broker Check

M&R Capital Management 1Q 2023 Market Review

July 07, 2023

The equity market was dominated in the second quarter by the Kabuki theater of the “debt ceiling crisis”.  Once again, both political parties postured for weeks before finally reaching agreement in the middle of May, which passed both houses of Congress and was signed by President Biden on June 3rd. Up until the draft agreement was concluded, stocks drifted sideways as investors asked themselves for the 78th time since 1917 if “this time was different.” It was no different this time than for any other such episode for much the same reason, that no elected official wanted to be responsible for the first debt default in U.S. history. When the debt ceiling issue was resolved equities experienced a predictable relief rally which remained focused on the technology, communications, and consumer discretionary sectors. Within these three sectors, Apple, Alphabet, Amazon, Broadcom, Microsoft, Netflix, Nvidia and Tesla provided the lion’s share of the gains. The other six sectors of the S&P 500 experienced modest gains or losses in value.

While equities experienced a narrowly based rally, interest rates resumed their upward march, after dipping lower briefly during the debt ceiling crisis.

Despite the Fed’s “pause” in interest rate hikes on June 14th, rates moved higher as an expected $1 trillion in deferred borrowing, which was necessary to rebuild the Treasury’s depleted cash balance, worked against the Fed’s “wait and see” policy of pausing rate increases. Further, the Fed made clear that the pause might well be followed by 1-2 additional increases, depending on forthcoming inflation data. Fed Chair Powell recently stated that he still perceives the major risk of doing “too little” to rein in inflation, not too much. Additionally, he remarked that he did not expect “core” inflation to return to the Fed’s preferred level of 2% either this year or next, as stronger than expected growth and a still tight labor market were the major themes in the Fed’s deliberations. Lastly Powell stated that he does not see a recession as the “likely outcome” of the Fed’s policy. 

The Fed’s focus on inflation might finally be bearing fruit as the central bank’s favorite inflation barometer, the Personal Consumption Expenditure Index (PCE) continued to moderate at a rate that slightly exceeded expectations. May’s reading increased only 3.8% year over year, the smallest gain since April of 2021, although it should be noted that falling energy prices and slowing food inflation, both highly volatile, contributed significantly to the improved picture. Over the past twelve months shelter costs rose 8%, food gained 6.7%, transportation services rose 10.2%, and electricity cost 5.9% more.

If rising interest rates and stubbornly high inflation are not enough to cause investors pause, then widespread anticipation of a recession either in late 2023 or in 2024 has dampened investors’ “animal spirits”. Fully 60% of forecasters expect a recession developing in the months ahead as most point to the cooling labor market, slowing sales, and contracting credit and profit margins. While most economists see the same data it is worth noting that the upcoming economic downturn will be the most anticipated recession in modern times. Recessions usually are unseen and unanticipated by most investors so it is worth questioning whether such a widely expected event will actually happen. Also, with the exception of the inverted yield curve and the U.S. Leading Indicators Index, there are few signs of an imminent recession as consumer spending remains buoyant and the job market remains strong, if cooled from the torrid state it was in last year. We would also point to the St. Louis Federal Reserve’s Index of Recession Probabilities below:

When the monthly reading remains under 1% (currently it is 0.62%) the odds of a recession in the months ahead are low. Perhaps the expected downturn will be deferred well into 2024, or will be relatively mild?

Stocks remain relatively expensive, although they are less expensive than at the same point last year. The forward twelve-month price/earnings ratio of the S&P 500 has declined to about 19, from nearly 22 last year. Moreover, according to Yardeni Research, the top eight mega cap tech stocks in the index account for 27% of its entire market capitalization and those stocks sport an average PE ration of 31. Therefore, the forward PE ratio of the 492 stocks of the S&P 500 ex the “Mega Cap 8” is a more reasonable 16.5, leaving ample room for the equity market advance to broaden beyond this handful of stocks in the months ahead. While we can see the prospect of this happening, we also see the risk-free return of 5.5% on six-month U.S. Treasuries as relatively attractive with the earnings yield on most stocks (excluding the Mega Cap 8) at 6%.

Wishing you a happy Independence Day and a pleasant summer, I am,