Globally, stocks gained in the second quarter with the advance led by developed markets, notably the United States, driven by enthusiasm over artificial intelligence (AI), which boosted big cap technology stocks.
The bulk of the market gains were made in June amid moderating inflation and signs the US economy remained resilient, despite higher interest rates.
Two main concerns weighed on sentiment coming into the quarter: the debt ceiling, as well as fears of credit tightening following the banking failures in Q1.
By the first week of June, with just days to spare, Congress and President Joe Biden resolved the debt debate, suspending the ceiling until 2025, in a deal that included some concessions on spending—expected to have little effect on economic growth.
In addition, while surveys and data from the Federal Reserve (Fed) showed lending slowed, it didn’t result in the credit crunch some had feared following the banking crisis in March.
Stocks Buoyed by AI Frenzy
The IT sector led the stock market advance in the quarter. Fervor around AI and the potential for a boom in related technology drove chipmakers, in particular, higher. The consumer discretionary and communication services sectors also performed well. Underperforming sectors included energy and utilities.
The US economy remained resilient in the first half of 2023, increasing the potential for a soft landing. However, a look across various sectors of the economy indicate economic momentum is slowing.
Soft business spending is one cause for concern. Business investment in R&D and equipment has fallen, indicating that many companies may be pulling in the reigns on capital expenditure (CapEx). Credit conditions have tightened, which makes it more challenging, especially for small to medium sized companies to finance such expenditures, and more expensive when they do.
The consumer is also showing cracks. Spending on credit cards is on the rise, and US consumers now owe $986 billion on their charge cards, according to Federal Reserve Bank of New York data. That’s a 17% jump from a year ago. The debt can be partly attributed to stubbornly high inflation, forcing households to lean on their credit cards to cover expenses. Consumer savings is also on the decline with the seasonally adjusted personal savings rate falling to 4.2% during the quarter, much lower than the long-term average.
The Supreme Court ruled out Biden’s plan to forgive $441 billion in federal student loan debt on June 30, 2023. This means nearly 37 million student loan borrowers will need to restart their monthly payments in October. Analysts who follow the retail industry estimate the resumption of student loan payments could shrink consumer spending by $14 billion per month.
The Labor Market
The US labor market slowed, with the unemployment rate hitting 3.7% in May, still very low by historical standards, but up 0.3% from the lows early in the year.
The report showed wage growth is slowing, which will be welcome news to the Fed, which cited wage inflation as one of the more complicated parts of the inflation picture. Wage growth has now come down to 4.3% from its peak of 5.9% in March of 2022.
Even though unemployment moved higher, job creation has been robust, with an average of over 300,000 new non-farm jobs created every month this year.
The Housing Market
Like the labor market, the housing market has been surprisingly resilient, with home prices as measured by the Case-Shiller US National Home Price Index only down about 1.7% year-over-year through April, with the index recovering this year after a trough at the end of 2022.
Though affordability is difficult with higher interest rates, demand remains strong as new home supply is constrained, and existing housing turnover is light, as current borrowers with low mortgage rates are locked into their current homes.
May’s closely watched Consumer Price Index (CPI) showed inflation has been cut by more than half from last year’s peak, coming down from 8.9% last June to 4.1% year over year in May.
While some of the most challenging parts of inflation from the last two years have been declining, including energy, the stickiest or most problematic part of the CPI has become service inflation.
Service inflation has grown in part because consumer behavior is still adjusting from the pandemic. When the economy was shut down, consumers bought mostly goods, like home improvement products or technology for working and learning from home.
When the economy reopened, consumers jumped at the opportunity to finally enjoy services and experiences like dining out, travel and leisure, and attending live events. Companies then scrambled to hire more workers and as a result had to raise wages. This helped to fuel inflation, as workers had more money to spend.
While inflation is falling, it’s not falling as fast as the Fed would like, and it’s likely they’ll continue to raise rates further to bring it back in line with their 2% inflation target.
After lifting the federal funds target 25 basis points (bps) at the May meeting to put the top end of the range at 5.25%, the Federal Open Market Committee (FOMC) unanimously voted not to raise rates at the June meeting. It was a hawkish skip, however. Participants telegraphed more hikes this year in their updated forecasts, dot plot, and comments following the meeting.
This propensity toward more rate hikes stems from the Fed’s expectations of a more resilient US economy, and they have indicated they’ll be closely monitoring coming data.
The committee acknowledged inflation is trending in the right direction but emphasized they need further evidence inflation is under control before calling an end to tightening.
Consensus macroeconomic views in 2023 have ranged from no recession to a mild recession, to a financial crisis, and back again. Forecasting economic shifts is difficult. The US economy is doing surprisingly well, and inflation has dropped significantly, though underlying increases in service prices remain stubbornly high.
With inflation remaining sticky, it’s expected the Fed may raise another 25 to 50 bps this year. While a recession is not a given, a slower economy will be increasingly sensitive to shocks.
While it’s impossible to predict what will happen to markets in the short term, the broader economy isn’t always reflected in the market. Equity markets are considered a forward-looking mechanism.
Markets have historically done well following a peak in inflation, the conclusion of a Fed tightening cycle, and a trough in consumer confidence. The market often bottoms before the economy, which is why it’s important to follow a long-term plan.
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