The S&P 500 has hovered near its 2023 high for the better part of a month. The recent mix of economic data, earnings, stress in the banking sector, and debt ceiling negotiations has brought little conviction as market participants remain on guard against an extensive range of outcomes. Though inflation is easing, it’s still far above the Fed’s 2% target. As such, monetary policy is likely to stay restrictive for longer than anticipated, and there is a rising probability of an accident. We have seen traces of this in the banking sector, but it is difficult to predict what is to come. With this backdrop, equity leadership has skewed towards stocks with certain defensive characteristics.
Inflation continued its downward trajectory in April with Headline and Core CPI moving slightly lower year-over-year. Shelter costs remain a sticking point in the survey data. However, there is a significant lag between market rents and survey data. With that in mind, the sharp easing in service pricing, excluding shelter, is of great importance. Despite ongoing wage pressure, the translation to higher service prices is softening. We are not out of the woods, but it is a step in the right direction for the Fed and likely gives them the cover needed to stop raising the Fed Funds rate. But, this does not indicate a rate cut. Financial conditions will remain tight for some time.
Despite best efforts from the Fed, Treasury, and FDIC, stress continues to permeate through the banking sector. Deposit bases in certain institutions are being eroded by a confidence crisis and comparably higher interest rates in money market funds. For investors, many regional banks appear to be dominos ready to fall and only the largest banks have come through unscathed. In such an environment, lending standards are unsurprisingly tightening across the industry as banks shore up capital. Credit could begin to dry up when it is most needed. So far, the economic impact has been minimal. The unemployment rate sits near a historic low at 3.4%, but leading indicators show a rise in layoff announcements and jobless claims.
The high level of uncertainty speaks to the current bifurcation in the market. Stocks with defensive characteristics are holding up while the most cyclical names lag. Defensive can mean several things in this landscape. Companies selling essential goods and services with pricing power are always defensive. Yet, many of the mega-cap stocks also have defensive elements to their businesses. For example, Apple and Microsoft have enormous cash reserves on their balance sheets, room for margin improvement, and products and services their customers cannot do without. This class of stocks is attracting money at the expense of those most vulnerable to a drawdown in the economy.
Preston May, CBE®
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