by Andrew Vanderhorst, CFA, CAIA, CFP®, Chief Investment Officer, Sanibel Captiva Trust Company
As we entered the second quarter, the primary concern among investors was the solvency of both the global banking system and the United States government. After the rapid failure of only a few U.S. and global banks, however, the crisis of confidence has largely abated. Furthermore, the last-minute bipartisan deal to raise the U.S. debt ceiling until early 2025 has averted a U.S. debt default and temporarily calmed investors’ nerves. We believe investors will now refocus on our overarching theme for 2023: the Federal Reserve’s mandate to eradicate inflation while trying to avoid too much economic pain.
The Federal Reserve (the Fed) decided to maintain interest rates at their current target range of 5.00 – 5.25% during their June meeting. While we believe the Fed is nearing the end of their rate-hiking cycle, we view their recent decision and subsequent commentary as a |”hawkish pause.” This means that the Fed is taking a brief break from raising rates but is likely to increase them again at a future meeting. This view is supported by the Fed’s newly updated dot plot, which shows that a majority of Fed board members expect at least two additional interest rate increases of 0.25% by the end of the year. Moreover, the Fed board members have revised higher their prior expectations for stronger GDP growth, improved employment, and higher core inflation in 2023. These changes align with recent economic reports. Most importantly, recent inflation reports show that core inflation (i.e., excluding food and energy prices) remains persistently above the Fed’s target of 2%. The bottom line is the current economic data suggests the Fed still has work to do on inflation and will likely keep interest rates ‘higher-for-longer’ than the market originally thought.
How has the market reacted to this higher-for-longer tone from the Fed? It has seemingly shrugged it off. Although the market has adjusted its rate expectations higher since the beginning of the year, it has also moved back into a bull market. Earlier this year, the market anticipated the Fed would soon start cutting interest rates. Now the market agrees with the Fed that interest rates will not be cut until 2024, at the earliest. Despite this shift in expectations, the market has largely disregarded the Fed’s restrictive monetary policy by staging a strong rally. The U.S. stock market, as measured by the S&P 500 index, has returned 16% year-to-date. You may ask: “Why is the stock market rallying if the Fed is still increasing interest rates?”
It’s important to note that not all economic sectors or companies participated in this rally. In fact, most of the S&P 500’s return can be attributed to a handful of mega-cap technology companies with exposure to the burgeoning field of artificial intelligence (AI). The mega-cap technology companies comprise over 20% of the S&P 500, so their performance can have a significant impact on the overall index return. A meaningful comparison is the S&P 500 Equal Weighted index, which holds the same amount of each stock, thus limiting the impact of any one company or sector. The equal weighted index has returned only 6% year-to-date, which seems more reasonable given the current environment. Unfortunately, there is not one benchmark or index that can consistently provide an overall gauge on the health of the stock market. Instead, we will be closely watching the second-quarter earnings reports from our companies to assess the continued impact of higher interest rates on their businesses.
We believe that we are getting closer to the end of this interest rate cycle, but there is much that remains uncertain. Therefore, we expect both the stock and bond markets to continue displaying high levels of volatility. All eyes will be on monitoring monthly economic reports to gauge the Fed’s likely decision at their next meeting in July. Despite the near-term uncertainty, we believe that a diversified portfolio of high-quality dividend and growth companies, combined with appropriate amounts of short-term bonds and cash, will help our clients meet their financial goals.