The Market Makes Its Own Path

The Market Makes Its Own Path

The equity market has the ability to defy the will of the largest proportion of investors.  The uncertainties that have plagued the market have been daunting.  The debt ceiling, threat of default, Federal Reserve, recession, Ukraine, and anemic China recovery have kept many investors on the sidelines.  Many hedge funds have been too bearish and have performed poorly during the strong rally.  These uncertainties have diminished somewhat, thus providing additional impetus to equities.  Resolving the debt ceiling crisis goes a long way toward removing a major economic and financial market impediment.

The Fed’s position is gaining more clarity as members articulate a “skip” policy – skip a rate increase at the June meeting in order to assess the lagged effect of the 10 rate increases, the banking crisis, and the flood of new securities that will be issued to finance government spending now that the debt ceiling has been lifted.  Despite the strong employment gain in May of 339,000 for non-farm payroll, these factors will dominate the June 13th and 14th meeting.  Fed member Philip Jefferson, the likely next Vice Chair, has already indicated the likelihood of a pause in June.  The Vice Chair’s position is usually in sympathy with the Chair.  The issue will then become July and the level of hawkishness articulated at the June meeting.

The other components of the employment report provided a sense of relief.  The wage gains remain contained, and the average work week and overtime have receded, suggesting less robustness.

Moreover, the Household Survey gave a different picture, with a decline in employment and a rise in unemployment.  Also, the employment component of the ISM Survey for services shows a contraction in May.

Furthermore, the Fed will be faced with the evolving crisis in the commercial real estate market, not only on the direct lenders, but also the impact on the banking systems.  According to data provided by TREPP, $1.5 trillion in commercial mortgages are coming due over the next three years.  Since many commercial loan mortgages are interest only loans, they are typically refinanced, or the property is sold.  This will be difficult to do in the current interest rate setting.  Interest only loans as a share of new commercial mortgage-backed security issuance increased to 88% in 2021 versus 51% in 2013.   Moreover, Fitch estimates that 35% of pooled securitized commercial mortgages that are coming due between April and December 2023 will not be able to be refinanced based on current interest rates and the properties’ incomes and values.

The pervasiveness of commercial real estate throughout the regional banking system may foster a rethinking of the blunt monetary policy tools.  It will be interesting to see how the Fed reacts to the flood of government securities that will be hitting the fixed income market.  The role they play in trying to mitigate volatility will provide some insight into future monetary policy.   Given all these developments, it seems likely in 2023 that the Fed may be forced to move towards a defensive strategy and away from an offensive one.  Any indication of such a change would go a long way toward solidifying the market’s rally.

Based upon technical indicators, the Nasdaq is in an established bull market and the S&P has just achieved bull market status by rising over 20% from the October intra-market and closing lows.  The Dow has further to go.  Artificial intelligence has taken center stage and helped power the market and has been a source of renewed confidence/optimism in the revenue outlook and growth opportunities for several high-tech companies, particularly NVIDIA.  Many other industries are positioned to benefit from the application of advanced AI functionality, including cyber security, defense and aerospace, industrial equipment, and others.  With quantum computing and AI, we could be entering a “new” computer age.  Most certainly, there has been a lot of AI hype, with companies jumping on the bandwagon.  In time, this will get sorted out.  We have written on these subjects and will continue to do so, hopefully providing meaningful insights.  In our judgement, this phenomenon is transforming and will impact the investment landscape for some time to come.

From a broader perspective, the level of the 10-year rate in the 3 ½ to 4% range is consistent with moderating inflation and is not particularly problematic for the equity market.  The high short-term rate in the 5% area is a headwind and does limit equity participation.  Given the high levels of cash positions of investors, particularly institutions, a change in direction could be a powerful force to drive stock prices higher.  That seems likely to be a 2023 event, but no one knows for sure.  The bifurcated economy – rolling recession on the goods side and growth on the services side – and the ability of many companies to manage their earnings throughout such a complicated environment are a testament to the resiliency of the economy.  The higher levels for earnings do provide a stronger foundation under the market’s sustainability!