Uncertainty is 2023’s Constant

Given how well risk assets have performed year-to-date, investors would hardly be blamed for following the adage “sell in May and go away.” Coming into the month, both Fixed Income and Equities posted strong positive returns despite persistent uncertainty, including further fallout from the regional-banking crisis. Interest rates kept climbing as concerns mounted that U.S. debt ceiling negotiations might drag all the way to the June 5th deadline, at which point the U.S. government would have limited funds left over to pay its obligations.

Fortunately, the White House and GOP negotiators reached an agreement – The Fiscal Responsibility Act – to suspend the debt ceiling until January 1, 2025, providing some market reprieve. According to the Congressional Budget Office (CBO), the deal would cut $975 billion in spending over ten years, trimming 0.65% of GDP in 2024 and 2025 and stiffening headwinds for an economy already contending with higher interest rates. Once the deal passes, better-balanced budgets could become a bigger priority, implying a reliance on the private sector to help the U.S. economy grow out of a potential recession later this year.

The state of the private sector in Q1 was better than expected as earnings season began to wrap up at the end of May. As of May 31, 98% of S&P 500 had reported a blended earnings decline of 2.1% versus an anticipated drop of 6.7% at the end of Q1. Though this performance was better than expected (as discussed in our April note), earnings revisions for the remainder of the year have not improved, suggesting muted optimism from some of the largest U.S. companies, including PayPal and Airbnb.

Boots-on-the-ground analysis from some retail companies suggests the consumer is “trading down,” opting for budget-friendly alternatives in certain areas of the market, such as bottled water and cereal. In Neuberger Berman’s CIO Weekly Perspective article, Is the Consumer Cracking?, we noted that higher-income consumers are increasingly visiting Walmart’s stores. McDonald’s modestly priced menus also grabbed greater market share across all income groups. Meanwhile, some higher-end clothing retailers bucked the budget trend: Urban Outfitters and Abercrombie both surged on better-than-expected earnings, adding to the overall confusion surrounding discretionary spending.

While the CPI remained elevated in April, we believe there is more than meets the eye when it comes to the perceived strength of the U.S. consumer. On a positive note, the labor market added 339,000 jobs in May, the highest rate since January, and continued to defy expectations of a slowdown by beating consensus estimates for the 14th month in row.

Clouds loom, however. Wage growth has begun to decelerate and pandemic-era excess savings have begun to shrink across income classes. In-house research from our NB Data Science team, as well as from Bank of America, suggest that higher-income consumers (who account for more than 60% of overall spending) are tapping their savings in the face of slowing job growth, modest bonuses and smaller tax refunds compared with previous years. Adding to the burden, the debt ceiling deal called for resuming student loan payments, at an estimated average of $380 per month, starting in September.

To skip, or to pause…that is the question

We continue to monitor the Fed’s path to combat inflation and maintain financial stability while trying to execute a soft landing. After deciding to increase interest rates by 25 bps in May, the Fed is now debating how to best communicate its plan at the June meeting. On one hand, we believe the Fed needs time to assess the impact of nearly 500 bps of rate hikes over the last 12 months; on the other, it also must retain flexibility to tighten further if needed. Whether the Fed decides to “pause” or “skip,” Fedspeak has leaned more hawkish than expected, with a handful of Fed members seeming to move away from mentioning rate cuts before the end of the year. On the back of this, the market is now pricing in fewer rate cuts by the end of the year (suggesting that rates may stay higher for longer). The market is also pricing in a higher likelihood of a rate hike in July, pushing policy-sensitive 2-year Treasury yields up nearly 40 bps in May.

AI-related rally in May further fuels YTD mega-cap returns, propping up the S&P 500

Despite broader economic uncertainty, U.S. equities edged higher in May. However, there is a clear bifurcation in returns between “mega-cap” companies, like Apple, Amazon, Alphabet, Meta, Microsoft, and particularly, NVIDIA – a semiconductor company that had a significant “beat and raise” in May that sent the stock price soaring – and the rest. In May, NVIDIA became the first chipmaker to hit a market cap of $1 trillion after a strong Q1 earnings in which the firm raised Q2 guidance around $4 billion above prior consensus due to strong demand for AI chips. NVIDIA’s stock price is up 159% year-to-date and is now the fourth largest company in the market cap-weighted S&P 500 Index.

Large companies like NVIDIA have a significant impact on the performance of the S&P 500, which is evident in the strength of returns so far this year. The gap in performance between the S&P 500 (market cap-weighted) and the S&P 500 (equal-weighted) is the widest it has been since December 1999. In fact, if the top ten stocks in the S&P 500 were stripped away, the Index would be near flat for the year (see the chart below). These year-to-date gains for mega-cap stocks can be partially attributed to the push for AI, with technologies like ChatGPT receiving increasing media attention, but also as a “flight to safety” for investors, who favor these companies for their quality characteristics such as strong balance sheets and stable cash flows.

A Tale of Two Indices

Source: Bloomberg, As of May 31, 2023. Each basket is market cap weighted. The constituents of each basket are determined by the average weight of stocks in the S&P 500 index from the start of 2023 through the end of May. These baskets are not rebalanced. The S&P 500 Index is represented by the S&P 500 Total Return Index.

Potential Portfolio Implications

Equities posted broadly positive returns, with Large Cap Growth outperforming on an AI-related rally and U.S. equities now outperforming non-U.S. year-to-date. Domestically-biased Small caps were down -0.09% for the month vs +0.4% for the S&P 500, hinting at muted price action from a more cyclically-oriented part of the market. We continue to maintain an underweight view on Equities given elevated valuations and the potential for further earnings declines. That said, the internal rotation in the market has affected valuation metrics unevenly, reminding investors to look for potential opportunities to add risk exposure over the course of the year.

Fixed Income markets struggled in May, posting broadly negative returns as hawkish Fedspeak and debt ceiling drama continued to push up U.S. Treasury yields. We continue to favor credit over equity given attractive yields and a benign default environment along with a preference for cash given its higher yields and optionality it offers. Given this backdrop, we recently upgraded High Yield and Emerging Markets Debt as there may be relative value opportunities to add risk to portfolios. In the event of rates volatility like we saw in May, we would look to capture higher yields at longer maturities as opportunities present themselves. As it stands, investors are being well compensated by the higher-rate environment in holding both cash and bonds at a fraction of the risk associated with equities.

Within Private Markets, we favor Private Debt following the emergence of banking system stresses, as tighter financial conditions are beginning to generate opportunities for providers of liquidity. While we maintain an overweight view on Commodities for portfolio diversification, where applicable, recession risks could hurt short-term demand.

Overall, investors are being “paid to be patient” in shorter-duration assets, reinforcing our continued belief that there is little opportunity cost to remaining cautious and defensively positioned for the time being. A higher-for-longer terminal fed funds rate, sticky (but easing) inflation, a hot (but cooling) labor market, extended equity valuations and weaker earnings will likely challenge markets throughout the year. We continue to favor a focus on diversified and high-quality assets while retaining the flexibility to add risk as potential opportunities present themselves.

Index Returns

Source: Bloomberg, total returns as of May 31, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg ExEnergy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.