Since our last update in April, equity markets have generally experienced upward movement, despite facing an additional rate hike by the U.S. Federal Reserve, persistent inflationary pressures, the looming threat of a recession, robust unemployment trends and political uncertainties surrounding the debt ceiling. However, the bond market has presented a contrasting interpretation of the economy, with bond yields rising and prices falling since the end of the first quarter. This is a departure from the first three months of 2023, when the equity markets and the bond market exhibited a synchronized movement, with both providing positive returns.

Looking ahead, Mutual of America anticipates that market volatility will remain elevated throughout 2023, as short-term data and policymakers’ comments continue to drive market sentiment. The key issues we’re closely monitoring include the Fed’s ability to manage inflation and avoid a recession, job market conditions, corporate earnings, resolution of the debt ceiling and the overall health of the financial sector.

Equity Markets Continue to Grind Higher

In the first five months of the year, there was a positive performance across major equity indexes. The S&P 500^® Index rose 9.6%, the Dow Jones Industrial Average experienced a modest increase of 0.3%, and the Nasdaq composite displayed significant growth, jumping 24.0%. It is worth noting that, during this period, the Nasdaq outperformed the Dow by the widest margin since 2001, particularly due to its focus on technology-related companies. The Russell 1000^® Growth Index outperformed the Russell 1000^® Value Index by over 20%.

Mega-cap growth stocks, characterized by strong financial positions and consistent revenue streams, thrived in this period. These stocks benefited as interest rates fell from their peaks and were considered safe-haven investments in a low-growth economic environment. As a result, they emerged as leaders in the year-to-date period through May, driving the overall performance of the equity markets.

Looking at this five-month stretch, the market-cap-weighted S&P 500 returned 9.6%, while the equal-weighted S&P 500 declined 0.6%. This indicates that, on average, the individual stocks within the Index either remained relatively flat or experienced a decline year-to-date, suggesting a narrow market. A similar pattern occurred in the Nasdaq Index, where the Nasdaq 100, comprising the 100 largest companies in the Nasdaq Index, posted a significant surge of 30.8% year-to-date. This impressive gain resulted in an increase of over $3.8 trillion in market capitalization in the Nasdaq 100, bringing its total to $16.5 trillion. However, this level is still below its peak of $20 trillion reached in late 2021.

Significant milestones were reached during the first five months of 2023, with Apple and Microsoft each reclaiming their $2 trillion market capitalizations. Apple ended the period at $2.8 trillion, while Microsoft stood at $2.4 trillion. Notably, Nvidia Corporation emerged as the top performer on both the Nasdaq and the S&P 500, experiencing a remarkable year-to-date increase of 156%. This surge propelled Nvidia’s market capitalization beyond the $1 trillion mark. The rise can be attributed to the growing investor interest in artificial intelligence (AI), as Nvidia’s chips are utilized in various AI-related technologies, including chatbots and other innovative solutions.

Bonds Show Strength, but Concerns Remain

Despite a slight decline in bond prices since the end of the first quarter of 2023, the bond market showed strength on a year-to-date basis through May, largely driven by decreasing interest rates starting in the latter part of 2022. The 10-year Treasury yield reached its peak at 4.23% last October. However, at the end of March it was at 3.47% and by the end of May it stood at 3.64%. Year-to-date, the 10-year Treasury generated a positive return of 2.9%, the 30-year Treasury yielded a return of 3.2%, the Bloomberg U.S. Corporate Bond Index rose 2.8%, and the Bloomberg U.S. Aggregate Index delivered a 2.5% return.

The persistently inverted yield curve continues to serve as a potential indicator of an impending economic slowdown. In 2022, the yield curve initially inverted on April 1, with the 2-year Treasury yielding more than the 10-year Treasury. Although the curve briefly returned to its normal shape, another inversion between the 2-year and 10-year Treasuries occurred in early July. Then, in late October, the yield on the short-term 3-month Treasury bill surpassed that of the 10-year Treasury. As 2022 drew to a close, the inversion intensified, and then, in the initial months of 2023, the spread widened further. Presently, the interest rates offered by 3-month Treasury bills are more than 1.58% higher than those provided by 10-year Treasury bonds.

The significance of an inverted yield curve lies in its reflection of how investors perceive the trajectory of the U.S. economy. If there is a prevailing belief in an upcoming slump or recession, investors tend to flock toward long-term U.S. bonds, causing the inversion. Notably, an inverted yield curve has preceded the 10 most recent recessions, underscoring its historical correlation with economic downturns.

Inflation Still a Challenge

Inflation continues to present an enduring challenge in the U.S., commanding the undivided attention of the Fed in its ongoing pursuit to curb its impact. The latest reports from three prominent inflation indicators consistently indicate levels surpassing the Fed’s average target of 2.0%, albeit with improvements observed since reaching their respective peaks.

In April, the Bureau of Economic Analysis’ Core Personal Consumption Expenditures (PCE) Index, which is the Fed’s favored inflation indicator, and which excludes food and energy costs, declined approximately 1% since the start of the year. However, it still remains at an elevated level of 4.6%. The Producer Price Index (PPI), often regarded as a precursor to changes in consumer prices, increased by 2.3%, while the widely recognized Consumer Price Index (CPI) rose 4.9%. The CPI measures the average price change for a fixed basket of consumer goods and services. One point worth noting is that the March CPI report marked the 25th consecutive month with inflation surpassing the Fed’s target rate of 2.0%.

Understanding the Debt Ceiling

The U.S. federal debt ceiling refers to the maximum amount of money that the U.S. government is authorized to borrow in order to fulfill its obligations, such as for Social Security payments, tax refunds, interest payments on the national debt and defense expenditures. The initial debt ceiling legislation was enacted by Congress in 1917 as a means to garner support for the country’s involvement in World War I. Congress intended to make the financial commitment more acceptable by imposing a limit.

Throughout the past century, adjusting the debt limit was a routine procedure that did not significantly impact or unsettle financial markets. In fact, since the end of World War II, Congress took action to raise, modify or temporarily suspend the debt limit on 102 occasions. However, in recent decades, the debt ceiling has become a subject of political contention, and it has been used as a tool to either increase spending or reduce expenses, depending on the agenda of the governing parties in both houses of Congress.

In the most recent impasse, after a prolonged period of intense negotiations, the two political parties reached an agreement, and on June 3, President Biden signed into law the Fiscal Responsibility Act of 2023, suspending the debt limit, currently set at $31.4 trillion, until January 2025. This action effectively prevented a government shutdown, which would have been the first-ever default on the nation’s debt obligations, potentially causing financial turmoil. This suspension also enabled the government to continue borrowing funds and fulfilling its financial obligations. Notably, this suspension conveniently extends beyond the next presidential election, effectively postponing the issue.

The agreement also encompasses other provisions, such as reductions in IRS funding, cuts to nondefense discretionary spending and the implementation of additional work requirements for food stamp recipients. While neither party can claim an outright victory, this agreement demonstrates the possibility of bipartisan compromise and highlights that politicians in Washington were able to avert a potentially disruptive event in the global financial markets.

Labor Market Shows Resilience

The labor market continues to exhibit remarkable resilience, which is a significant factor for the Fed to consider. Despite a period of cooling, the May payroll data surpassed expectations. Nonfarm payrolls experienced a substantial increase of 339,000 jobs, far exceeding the consensus estimate of 195,000. Moreover, average hourly earnings remained steady at 4.3%, consistent with recent trends. However, the overall unemployment rate ticked upward to 3.7%, from 3.4% in April.

The Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS) for April revealed that there were 10.1 million job openings nationwide. This indicates that there are more job opportunities available than there are job seekers, underscoring the tightness of the labor market. The Fed’s objective is to prevent wage-price spiral inflation, where higher wages lead to increased costs for companies that may subsequently pass on the burden to consumers. Hence, it is crucial for the Fed to cautiously manage the pace of job market growth in order to curb inflation without causing a significant surge in the unemployment rate.

The Economy Is Starting to Slow

In an attempt to address rising inflation in early 2022, the Fed embarked on a proactive path of raising interest rates beginning in March 2022. To date, a cumulative increase of five percentage points has been implemented, and the repercussions of 10 rate hikes are beginning to manifest in the economy. Nevertheless, it is essential to recognize that interest rate policy is a broad tool with prolonged and uneven effects. There are indications that the rate hikes are starting to impact specific sectors of the economy.

The housing market is one area where the influence is particularly noticeable, as higher mortgage rates are causing a slowdown. In 2022, the 30-year fixed mortgage rate commenced at 3.1% and reached a peak of 7.1% in November. As of early June, the rate stood at 7.0%. Not surprisingly, May mortgage applications were down 5.7%.

Another significant economic indicator is the ISM Manufacturing Index, also known as the Purchasing Managers’ Index. While the initial reading in 2022 was 58.8, by May 2023, it had experienced a substantial decline, contracting by nearly 11.9 points to 46.9. This decline signifies a reduction in ordering activity at the nation’s factories.

Commodity prices have started to recede, indicating a potential economic slowdown. This marks a reversal from a year ago, when the escalation of tensions between Russia and Ukraine led to soaring prices for energy and grains. As of May 31, 2023, the S&P GSCI Commodity Index was down 13.4% year-to-date, and prices of energy, grains and other raw materials have all declined.

Considering the recent upheaval in the banking sector, we anticipate certain immediate consequences, including increased regulations on small and regional banks, tightened lending standards and a decrease in the overall number of loans. Although these changes were not intended by the Fed, they are expected to significantly impact lending activity, which will ultimately have a dampening effect on the economy.

Consequently, specific sectors of the economy are beginning to slow down. Currently, there is a widely anticipated 76% probability that Fed officials will maintain current interest rates during their next meeting on June 14, according to Bloomberg – World Interest Rate Probability. This approach will provide them with more time to analyze the economic ramifications of the previous 10 rate hikes and the recent banking turmoil. However, there is a 50% probability that they may reconsider rate hikes at the July 26 meeting if warranted by financial conditions.

Equity Valuations Worth Watching

There has been a notable change in the equities landscape, shifting the focus from last year’s “multiple compression” narrative to concerns surrounding a potential slowdown in growth or even a growth recession for corporate earnings. During the first quarter of 2023, the S&P 500 experienced a 1.5% decline in overall earnings, and it is expected that this downward trend will continue, with a 6.1% drop projected in the second quarter. One contributing factor to this earnings decline is the reduction in profit margins. Despite healthy revenue growth, rising costs have exerted pressure on margins, leading to a squeeze in profits.

Adding to these concerns, the current price/earnings ratio for the S&P 500, as reported by FactSet, stands at approximately 18.9 times, surpassing the year’s initial value of 16.7 times and surpassing the 25-year historical average of 16.8 times. This suggests that stocks are currently not priced at a bargain. While multiples have expanded since the beginning of the year, the market breadth, which indicates the number of stocks participating in the market rally, has been narrow. A mere eight stocks, namely Alphabet, Amazon, Apple, Meta, Netflix, Microsoft, Nvidia and Tesla, now account for a significant 30% of the weight in the S&P 500. To put it in perspective, these same stocks represented only 22% of the market capitalization at the start of this year.

Summary

Despite various challenges, such as the Federal Reserve’s rate hike, inflationary pressures, the potential for a recession and uncertainties surrounding the debt ceiling, equity markets have generally shown upward movement. Major indexes like the S&P 500, Dow Jones Industrial Average and Nasdaq have posted positive returns, with the Nasdaq outperforming the Dow by the widest margin since 2001. Mega-cap growth stocks, particularly in the technology sector, have led the way in driving the overall performance of the equity markets. However, the bond market recently presented a different picture, with rising bond yields and falling prices, indicating a divergence from the synchronized movement with equities seen in the first quarter of this year.

Looking ahead, Mutual of America expects market volatility to remain elevated throughout 2023. Factors like inflation management, job market conditions, corporate earnings, resolution of the debt ceiling and the overall health of the financial sector will be closely monitored. While equity markets have shown strength, concerns over equity valuations, declining corporate earnings and a potential slowdown in growth are emerging. The housing market has been impacted by higher mortgage rates, and the manufacturing sector has contracted. Commodity prices have started to recede, indicating a potential economic slowdown, and changes in the banking sector may lead to tightened lending standards. These and other factors suggest that certain sectors of the economy are beginning to slow down. With all of this in mind, and amidst such uncertainty continuing in the months ahead, investors need to carefully assess their investment strategies.

Jamie Zendel is EVP, Head of Quantitative Strategies, and Erik Wennerstrum is VP, Quantitative Research, at Mutual of America Capital Management LLC.

Past performance is no guarantee of future results. The index returns discussed above are for illustrative purposes only and do not represent the performance of any investment or group of investments. Indexes are unmanaged and not subject to fees or expenses. The index returns above reflect the reinvestment of distributions. It is not possible to invest directly in an index.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

The information has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. Mutual of America is not responsible for any subsequent investment advice given based on the information supplied.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Securities offered by Mutual of America Securities LLC, Member FINRA/SIPC. Insurance products are issued by Mutual of America Life Insurance Company.