Market Commentary - May 2023

Monthly Update

There were two stock markets in May 2023, mostly large technology companies and then everything else. Excitement over the new iteration of artificial intelligence and the OpenAI product ChatGPT sparked quite a rally in the very biggest technology names like Microsoft, Alphabet, Meta Platforms and the chip company that benefits the most right now from this trend, Nvidia.[1] Nvidia rallied 36% in the month of May as they reported a much better than expected earnings report as they currently are the main supplier, market share wise, of AI dependent chips[2]. Microsoft, the big investor in OpenAI, saw its stock rally by almost 7%, Alphabet was higher by 14.5% and Meta was up by 10.2%[3]. These stocks, along with some other AI beneficiaries helped to drive a 5.8% in the NASDAQ[4]. Outside of that though, markets were much more mixed. The S&P 500 was essentially flat, up 0.3% and the small cap Russell 2000 was lower by 1.1% and in the red for the 4^th straight month[5].

I’m not going to pretend to be an expert on AI but according to a Harvard University paper, “By the 1950’s we had a generation of scientists, mathematicians, and philosophers with the concept of AI culturally assimilated in their minds[6].” This same paper talked about a 1950 paper from Alan Turing titled Computing Machinery and Intelligence “in which he discussed how to build intelligent machines and how to test their intelligence.” My point here is that AI is not new. We are just experiencing an incredible new iteration of it. It’s exciting and scary at the same time. It will certainly be a game changer for many companies and certain industries but trying to quantify the benefits right now is difficult.

The stock market, and more so the US Treasury market, was also influenced by expectations that the Federal Reserve would not increase interest rates at their June 14^th meeting. At the end of May, Fed Governor, and likely the new upcoming Vice Chair, gave a speech where he talked about “skipping a rate hike at a coming meeting” which “would allow the committee to see more data before making decisions about the extent of additional policy firming.” Philadelphia Fed President Patrick Harker, who does vote, gave similar comments, and joins a like mind as to another voting member, Chicago Fed President Austan Goolsbee. With that being said, yields actually jumped higher in May as the market still doesn’t think the Fed is done raising rates, even with a pause in June as the market is pricing in a greater than 50% chance of a July hike as of this writing[7].

The 2 yr. Treasury yield rose 40 basis points to 4.40% which was the highest monthly close since February[8]. The yield curve inverted again in the month of May as the 10 yr. yield was up by 22 basis points to 3.65%, also a three-month high close[9].

The other drama of the past few months which culminated in May, was the US debt ceiling debate and its eventual passage. We fielded many questions and calls on this and our response was always, “it will get raised as it always does” and why we were never particularly concerned. All is not well with the finances of the US government though, as debt will continue higher and thus the US Treasury has more and more debt to sell to the rest of us. The risk of these rising debts and budget deficits is that it continues to crowd out the financing of the private sector as more money is shifted to buying Treasuries.

International markets were mixed in the month as well. The Japanese Nikkei closed up 7% in May to a 33-year high, but the Euro STOXX 600 index was lower by 3.2% after its year-to-date outperformance[10]. Yes, the Nikkei is still below its 1989 peak but is closing in, about 17% below that bubble high[11]. The CSI 300 index in China finished the month down 5.7% on concerns with a more muted economic reopening than hoped for[12].

We’re now about 2 1/2 months removed from the bank failures of SVB and Signature Bank that was then followed by First Republic. Fortunately, we haven’t seen any others, but all eyes are on the consequences when it comes to bank lending, both the supply and the demand for loans. These factors will significantly impact economic activity moving forward. In May, we saw the updated Senior Loan Officer Survey from the Fed where it reflected further tightening of bank lending standards but also reduced demand for loans. According to the Fed, US bank loans make up approximately 20% of all lending. Although this may not be considered a substantial portion, small and medium-sized businesses are very dependent on small and medium-sized banks for credit. As of the end of May, commercial and industrial loans outstanding shrunk to the least since last October.

The impact of a pullback in the extension of bank credit will be felt particularly hard in commercial real estate which I covered in the April commentary. At the time, I mentioned the two challenges being faced in CRE right now, one is office properties and the other is capital structure in terms of loans coming due this year. The lack of credit is also negatively impacting new construction as it’s just more difficult to get a loan.

Air came out of the China reopening story in May as the initial hope for a sharp recovery hit some realities. The positives, as seen in the rest of the world when it reopened, were the big lift in spending on leisure, travel, tourism and eating out. We’re talking about 17% of the world’s population that was essentially locked up for three years, that wants to make up for lost time. Chinese manufacturing has been slower to recovery though because of lackluster demand globally as consumers have shifted their spending to services. Also, the US and Europe are currently experiencing a manufacturing recession, so China is no different. Lastly on China, their residential real estate market continues to digest the huge deleveraging that is needed on the part of developers and much less new construction is taking place as a result. The focus is more on finishing existing projects.

The Economy and Inflation Outlook

Inflation rates in the US, Europe and in other places outside of Japan seemingly, have peaked as the recent monthly numbers are coming down. A drop in goods prices has led the way but we should be on the cusp of seeing moderation with services. The big question now is where inflation eventually settles out in 2024. Are we going back to the days of 1-2% inflation that we saw pre-Covid or is something structurally higher a possibility (in the 3%-4% range)? I believe in the latter outcome, which if correct, will lead to a higher for longer interest rate backdrop.

The US economy has seen many mixed signals over the past month that is enough to make one’s head spin if trying to figure out what happens from here. After hearing from a slew of consumer reliant companies over the past few months in quarterly earnings reports, spending strength is being seen in travel, tourism, leisure, restaurants and bars. With regards to spending on goods, it’s mostly been on non-discretionary items like food, drug, and beauty products. Discretionary things like electronics, furniture, jewelry, and cars are seeing more discriminating spenders. Home builders are filling in the gap of a dearth of supply of existing homes. US manufacturing is in a recession as seen in the monthly ISM survey. Capital spending has been somewhat muted as businesses trim spending in the context of a “challenging macro-economic environment” that I heard so many companies cite in their quarterly earnings conference calls.

I want to expand more on the housing market, because of its significance to economic activity as the National Association of Home Builders estimates the industry contributes up to 15%-18% to US GDP. Because of the very sharp rise in interest rates in a very condensed period, most mortgage holders have an interest rate under 5%, according to Fannie Mae. What that has led to is the lack of desire to give that up, so the inventory of existing homes is very muted. This in turn is leading to less home sales of existing ones and more of an opportunity for builders to add more supply and take market share. So where one would think home prices would fall in order to mitigate the impact of a doubling of mortgage rates, home prices are remaining high, and thus maintaining the unaffordability challenge for many.

Conclusion

As discussed in the beginning of this commentary we have a tale of two markets, one being tech and the other being just about everything else. This so-called bad breadth hopefully will be reconciled with the laggards catching up to the winners but that is highly uncertain right now. While the Fed will likely not raise interest rates at their next meeting, we still have to get used to a period of time where interest rates will remain elevated which will in turn impact everyone that has debt coming due this year and next on an ongoing basis. This will be a headwind overall for economic growth and possibly for markets. The Fed will also continue on with quantitative tightening. On the other hand, hopefully we’ve seen the peak in interest rates and this new environment will be something we can acclimate to without much damage. A big question too is how the market will be able to absorb all the US Treasury issuance and where the clearing prices will be as US debts and deficits continue higher.

Whatever comes our way though, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor.

Disclaimer

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Approval #444685-1

[1] No assumption should be made, nor is implied, that an investment in the securities identified were or will be profitable. While some Bleakley clients may have bought or sold such securities during May 2023, any specific references made herein to the individual securities referenced herein are solely for market commentary purposes and do not represent any specific recommendations to buy or sell such securities.

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] The History of Artificial Intelligence, By Rockwell Anyoha, August 2017

[7] Bloomberg

[8] Bloomberg

[9] Bloomberg

[10] Bloomberg

[11] Bloomberg

[12] Bloomberg