New Highs in the Face of Liquidity Concerns
The S&P 500 hit 2023 highs on the back of last week’s debt-ceiling deal and a frenzy of buying in artificial intelligence-related stocks. The Labor Department released the May employment report Friday that showed a net creation of 339,000 jobs, well above expectations and a meaningful gain compared to April’s 264,000. Yields rose in the wake of the jobs number with market participants positing that the stubbornly tight labor market will force the Fed to continue to raise the policy rate at the upcoming meeting.
Since March 2022, the Federal Reserve has raised its policy rate at 10 consecutive meetings, with the last two increases following turmoil in the banking sector that led to the collapse of four lenders. Now, Fed Chair Jerome Powell and several of his colleagues want to pause at their June meeting to assess the outlook as the lagged effects of rate increases, and the wide-scale credit tightening by banks, works its way through the system. Pausing rate increases presents some hazards however. Officials have signaled to markets that they planned to bring rates to a restrictive level and hold them there for some time. Markets are anticipating the Fed will cut rates later in 2023. Skipping a rate hike in June could make it more difficult for officials to restart, if needed. The public could lose faith in the Fed’s ability to bring inflation back to 2% the longer it stays above target. Progress on the inflation front has slowed, notably in the services sector. The Fed’s preferred measure, one that excludes food and energy prices, rose 4.7% for the 12 months ending April. Eliminating outlier prices, a measure produced by the Dallas Fed showed inflation running at 4.8% on an annual basis, more than double the Fed’s target. This sticky core inflation has presented the Fed with a sharp trade-off: squash growth with even higher rates or live with some inflation. Markets are no longer pricing in multiple rate cuts in 2023, warming up to the view that rates may stay higher for longer to combat inflation. Attention may then shift to the broader U.S. fiscal position with rates staying higher.
With a resolution to the debt ceiling now in the rearview mirror, the recent quarterly refunding statement announced plans for nearly $480 billion of new Treasury issuance this quarter; and some estimate it could balloon to as much as $1 trillion over the next few months as the Treasury Department replenishes its coffers. There has never been that much issuance outside of the 2008 financial crisis and Covid, and presents a significant potential drain on liquidity. Bank of America has estimated that the issuance wave could have the same economic impact as a quarter-point interest rate hike by the Federal Reserve. Total public debt as a proportion of GDP has risen to approximately double the level it was in just 2005. Also, the budget deficit is already bloated at a time when the economy is overheating. Higher interest rates will raise debt servicing costs substantially and perpetuate unsustainable debt levels.
The enthusiasm in the riskiest corners of the equity market and the bounce in yields appear to suggest broad economic optimism. The 3-month gap in performance between the benchmark market cap weighted S&P 500 and equal-weighted S&P 500 index is the widest on record. In fact, the benchmark S&P 500 contains more losers than winners in 2023, not a statistic one would expect with the index up over 11% year-to-date. While the excitement around artificial intelligence has driven much of the move in equities, a deteriorating liquidity backdrop is likely to put downward pressure on equity valuations in the coming months. The Conference Board’s Leading Economic Indicators are signaling a recession sometime in the next 12 months. This coupled with EPS disappointments ahead as revenue growth slows and margins contract further could prove to be a stumbling block for further gains. All eyes will be on the Fed as they embark on potentially the next phase of their battle to tame inflation.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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