Previous week's weekly market wrap

Tech continues to drive markets as investors await two key events: the U.S. debt-ceiling resolution and the June Fed meeting

• While stock markets were broadly flat this past week, one sector stood out in that it was up over 4.0% for the week: information technology¹. In fact, the technology sector is one of just three sectors in the S&P 500 Index that is positive year-to-date, along with consumer discretionary and communication services. Technology and communication services are now up over 30% this year already, well into bull-market territory¹. Meanwhile, each of the other eight S&P 500 sectors is negative this year thus far, perhaps reflecting the uncertainty around the ongoing U.S. debt-ceiling standoff, future path of Fed rate hikes, and potential economic softness.
• Market leadership has clearly been narrow this year, led by just a few sectors and a handful of large-cap technology companies, and in many cases driven by valuation expansion. For long-term investors this is not always a sign of healthy market performance, as it can reflect overcrowding in one area and uncertainty around the broader economy in others. In our view, we would expect to see a broadening of market leadership, particularly as an economic downturn and subsequent recovery take shape, perhaps in the months ahead. In this backdrop, a recovery playbook could include small-cap stocks, cyclical sectors and international equities, alongside technology and growth parts of the market.

Figure 1. S&P 500 sector outperformance this year has been led by technology and growth areas

What is driving the outperformance in the technology sector?

There may be a few reasons behind the recent technology outperformance. First, growth sectors were the biggest laggards last year, and they experienced the sharpest declines in valuations, perhaps making the technology and growth areas more appealing to investors looking for bargains. Secondly, many large-cap technology stocks have become part of a defensive strategy more recently. These companies have certainly shown resilience through this past earnings season, highlighting their defensible business models and strong financial positions, and returning value to shareholders through share-repurchase programs.

Finally, in our view, many investors see the attractive growth potential of the emerging artificial intelligence (AI) space – sparked by ChatGPT / Google Bard, etc. – which could be in the early innings of a multiyear growth cycle. In fact, last week semiconductor company NVIDIA, whose stock soared after it raised its revenue guidance well above analyst expectations, pointed to generative AI as a critical growth driver. Many investors who are sitting on the sidelines, given the better yields from cash-like instruments, need a compelling reason to enter the markets, and the growth potential of AI technologies may be where some of this cash is now flowing.

Figure 2. The technology-heavy Nasdaq has been sharply outperforming the broader S&P 500 and Dow Jones indexes this year

Where do we stand on the U.S. debt ceiling? A deal seems imminent

Part of the uncertainty that investors face, near-term of course, lies in the ongoing U.S. debt-ceiling negotiation. However, according to recent reports, a tentative deal is taking shape ahead of the June 1 noted deadline (the X-date) that could increase the debt ceiling and cap federal spending for two years, except for the military and veterans². Some other details include a potential 3% rise in defense spending next year, a measure to upgrade the nation’s electric grid, and permits granted for pipelines and other fossil-fuel projects². There is also a focus on rescinding some of the $80 billion allocated for the Internal Revenue Service as part of the Biden administration's Inflation Reduction Act².

Members of Congress have vowed to work through the long holiday weekend to continue to push toward a deal, and, in our view, we could see a negotiated agreement announced in the coming days. Last week, the Fitch rating agency put the U.S. AAA credit rating on watch for a potential downgrade, citing the debt ceiling and default as a key concern. However, Fitch also noted that the highest-probability scenario remains for a resolution before the X-date.

Keep in mind that there is historical precedent for Congress to come together in a "last hour" debt-ceiling deal, typically with concessions from both sides. Since 1960, the debt ceiling has been raised 78 times in the U.S., including 20 times since 2001 alone². The Treasury Department has had to use extraordinary measures in six of these standoffs before Congress was able to reach an agreement.

From a market perspective, while politics generate substantial headlines, they tend not to be a long-term driver of market performance. In the last several instances of more severe debt-ceiling showdowns, including 1995, 2011 (when S&P downgraded the U.S. credit rating), and 2013, markets were higher in the 12-month period after the debt ceiling was resolved. More broadly, market performance tends to be driven more by economic and earnings fundamentals rather than the political landscape.

Figure 3: Historically, the S&P 500 is higher in the 12 months after a debt-ceiling standoff:

Could a Fed pause be short-lived?

As we look past the U.S. debt ceiling, the next market catalyst on the horizon perhaps lies in the June 14 Federal Reserve meeting. In recent weeks, several Fed officials have indicated that the Fed's focus remains squarely on fighting inflation, which remains too elevated for comfort. Despite better trends in headline inflation, PCE (personal consumption expenditures price index) inflation data last week moved higher, and services inflation remains persistent, driven by a solid labor market and still-elevated wage growth. We saw last week that U.S. GDP growth for the first quarter was also revised upwards modestly to 1.3% annualized (versus the prior estimate of 1.1%), with consumption still resilient at 3.8%². The Fed's own GDP-Now tracker is currently pointing to a solid 2.9% annualized growth rate for the second-quarter U.S. GDP.

With a strong labor market and broadly healthy economic backdrop, some Fed officials have been wondering if further rate hikes may be prudent to continue to keep pressure on inflation. In fact, markets are now also starting to price in one additional rate hike by the Fed, perhaps at the June or July meeting, bringing the fed funds rate to 5.25% - 5.5%¹. We have seen some of this reflected in Treasury yields moving higher in recent days as well, particularly on the shorter end of the yield curve, which tends to be more driven by Fed rate-hike expectations.

In our view, the Fed is likely leaning toward a pause in rate hikes for now, particularly given recent uncertainty in the regional banking sector and some tightening of credit conditions, but any decision will likely be highly data dependent from here. We will get critical economic data ahead of the June 14 meeting, including a U.S. nonfarm jobs report and CPI inflation data for the month of May, both of which are expected to show some cooling and could help determine the next move in interest rates.

Figure 4: U.S. Treasury yields have moved higher, particularly for shorter-term bonds, as expectations rise for another Fed rate hike once again

Opportunities may be emerging for equity and bond investors

Overall, we would expect the markets' recent narrow leadership to potentially persist in the near term, as investors gravitate toward an approach that favors both technology and growth sectors and cash-like bonds. However, as the economy goes through a potentially mild recession and reemerges, we would expect market leadership to broaden. After a bear market over the past 16 months or so, we see opportunities forming in both the equity and bond space.

In equities, we would use periods of volatility ahead as opportunities to diversify portfolios, rebalance, and add quality investments at potentially better prices. As market leadership broadens, we would favor both cyclical and quality growth sectors, as well as small-cap and international stocks.

In bonds, investors recently have also gravitated towards CDs, money-market funds, and shorter-duration fixed income, as yields remain favorable. But there may be reinvestment risk over time, especially as some of these instruments come due in a potentially lower-rate backdrop. We see opportunities to complement these  investments with longer-duration fixed income, particularly in the investment-grade space. These bonds have the potential to not only lock in better yields for longer, but they also have the opportunity for price appreciation, especially as central banks pause and, over time, move interest rates lower.

Mona Mahajan,
Investment Strategist

^{Sources: 1. Factset. 2. Bloomberg}

Weekly market stats

^{Source: Factset 05/26/2023. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 5/29/2023.}

The week ahead

Important economic data being released this week includes labor market and consumer confidence data.