Markets a Mixed Bag in May as Investors Weighed Many Issues
I’ll answer that question shortly, and address each of the issues mentioned above one by one. But first, let’s take a quick look at how the markets overall performed in May. As for the stock market, the Dow Jones Industrial Average finished the month down by nearly 3.5%, although the S&P 500 was up by about 0.3% and the Nasdaq added a whopping 5.8%.* The bond market saw another pullback as long-term interest rates again took a big jump. The yield on the 10-year government bond rose from as low as 3.37% on May 4 to as high as 3.83% on May 25, ending the month at 3.64%.**
So, why were the S&P and Nasdaq up while the Dow was down last month? The answer is AI. Both the S&P and Nasdaq contain many technology-based companies, and many of these companies are developing new tools and products in the field of artificial intelligence. In May, any stock that was even remotely related to AI took off. Naturally, the money used to purchase those stocks had to come from somewhere, and in many cases, it came from investors pulling money out of other more conservative stocks, which is why we saw the Dow go down as the Nasdaq and S&P both went up.
Does all this sound familiar? It should, because new and emerging technology frequently creates a stock market bubble of this sort. Often these bubbles just sort of deflate, but sometimes they can burst, with devastating consequences. That’s what happened with the infamous dot-com bubble of the late 90s. Could the same thing happen with the AI bubble? I don’t think there’s any sign of that yet, but it is something to keep an eye on—although even in a worst-case scenario the effect would likely be minimal for those invested mostly in bonds and bond-like instruments.
The Debt Threat
As for the debt ceiling showdown that caused mounting economic anxiety all month, in late May both the House and Senate finally approved a bill to raise the nation’s debt limit, and Joe Biden signed it into law on June 3.*** Once again we, as a nation, narrowly averted the risk of defaulting on our debts to other countries. I say “again” because — as with the latest tech bubble — this debt ceiling “crisis” was nothing new. And while the media likes to play up the idea that failure to raise the debt ceiling by a certain deadline has crashed out the whole economy in the past, that’s mostly just typical media hype. Remember back in 2012 we did miss that deadline and the result was just a partial government shutdown while politicians continued hammering out a deal. The point is these debt ceiling deadlocks are an inevitable part of political gamesmanship. But are the potential stakes of this game as high as the media would have you believe? Probably not.
So, we’ve covered two of the big issues investors had their eyes on in May: AI stocks and the debt ceiling. But what about that third issue: regional banks? As you recall, the sudden failure of two regional banks back in March sent shockwaves through the markets and triggered fears that another national banking crisis could be brewing. Although no more banks have failed since, a new report by the FDIC finds that the number of regional banks at risk in today’s economy has risen from an estimated five to over 40.****
The primary source of risk is the same one that caused those two initial bank failures in March: The Federal Reserve.
As I explained at the time, the Fed’s aggressive schedule for raising short-term interest rates to fight inflation over the past year has created many hardships for banks, who depend on an upward-sloping yield curve to make money. As the bond market has pushed back against the Fed’s rate hiking in recent months, the yield curve has become increasingly inverted. While the Fed’s benchmark short-term rate is now at 5%, long-term rates are, as of this writing, still under 4%. When short-term rates are higher than long-term rates, banks must pay more to their depositors over time, but they can’t raise the fixed interest rates on the loans in their books. This compresses their net interest margin, and it becomes cost prohibitive for them to lend money.
An inverted yield curve hurts banks, especially smaller regional banks, in other ways as well. So, with the Fed still signaling that more rate hikes may be in store, it’s no surprise that the number of at-risk regional banks has risen. The one silver lining here is that even if another banking crisis were to occur, it wouldn’t be anything like the one that triggered the Financial Crisis back in 2008. This one would be entirely Fed induced, meaning the Fed is well positioned to control the damage, which they have already taken preventive steps to do.
Fed Pauses, But Isn’t Finished
Those steps include finally “pausing” their rate hiking efforts at their latest meeting, which took place June 14.***** The pause was expected due not only to the troubling FDIC report, but because economic growth is slowing, and many economists are still forecasting a recession. Despite the pause, however, the Fed also signaled two more rate hikes may be in store this year.
So, what does it all mean for your investments? Well, the most significant impact from May for most of you was that big spike in long-term interest rates. As is always the case, it created a headwind that pushed values down in most of our bond and bond-like instrument portfolios by about 1-to-2% for the month on average, depending on your individual holdings. The good news is that most of you are still up by 4-to-5% for the year, which is very good after five months for a conservative portfolio of bonds and bond-like instruments. And, the even better news, of course, is that any increase or decrease in values is always largely irrelevant when you are investing for interest and dividends because your income return remains unaffected.
*“Nasdaq Adds Nearly 6% in May,” CNBC, May 31, 2023
***“Senate Passes Debt Limit Bill, Staving Off Calamitous Default, NY Times, June 1, 2023
****“FDIC Says Banks With Weaknesses Increased in Q1,” Bloomberg, May 31, 2023
*****“Federal Reserve Holds Interest Rates Steady, Forecasts Two More Rate Hikes This Year,” Yahoo News, June 14, 2023.
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