Debt Limit Commentary
The idea of the United States defaulting on its debt is (and was) a very low probability event. The effects would be both immediate and devastating to global financial markets. Nevertheless, loud voices advocate rejecting the Biden/McCarthy Agreement finalized on Sunday. Unfortunately, our system led us to this place. The U.S. is the only major developed country where an elected assembly must approve debt limit increases. Spending is Congress’s responsibility, and the budget process determines spending levels. Perhaps it is a broken system that neither party has been able to contain spending and deficits, which led to the current House position on using the debt limit vote to curtail expenditures. Nonetheless, this political battle shows the stress from too much spending with too little revenue combined with seemingly intractable and rising costs for Social Security, Medicare, and Defense and the rising cost of servicing our existing debt.
One can never be too confident about the stock market’s near-term direction, but the headwinds are strong. Nevertheless, we think some key drivers will impact market performance over the next 6-12 months, including risks and potential opportunities.
AI and Technology
The past couple of weeks have seen an extraordinary rise in the prices of stocks connected to artificial intelligence (AI). On May 25th, NVIDIA, known for its high-end chips used in gaming, now a leading AI chip manufacturer, posted blockbuster sales and earnings. The market rewarded this performance with a 30% increase in NVIDIA’s share price, giving it a market value of $1.0 Trillion. The quarterly revenue? $7.2 Billion. It is difficult to see any mathematical path to this investment paying off at this price. NVIDIA now has a market value in the top 5 publicly traded companies. We like the semiconductor sector but think prices have gotten way ahead of longer-term returns and expect prices are close to topping out at these levels.
The top five companies in the S&P 500 represent 22% of the index and have accounted for virtually all the return in the S&P 500 in 2023. The list includes Apple (7.3% of the S&P 500 index), Microsoft (6.6%), Amazon (2.7%), NVIDIA (2.0%), and Google (Class A 1.8%; Class C 1.6%). Apple’s market value (market capitalization) is currently slightly higher than the market cap of the entire Russell small-cap stock index (representing roughly 2000 companies). The valuations for these large companies relative to the total stock market are at extreme levels. These are great companies but overpriced and vulnerable to a sharp market decline. While the rise in technology shares may lead to some feeling of missing out, the tech-heavy NASDAQ index is still close to 13% below its January 2022 peak. The S&P 500 is also a little under 11% under its January 2022 peak.
We are seeing a solid price performance in the technology sector, recovering from the 2022 sharp decline. However, it is not likely to continue without participation by other sectors and smaller firms, where returns have been anemic relative to these dominant stocks. Here are two charts illustrating the issue from January 1, 2022, to date and year-to-date. Note: 2023 leaders are just recovering lost ground from 2022.
Returns from 01/01/2022 to 05/26/2023
Returns Year-to-Date
Headwinds
Besides domestic political infighting, geopolitical tensions, banking system stress, and higher interest rates, we are starting to see some clear evidence of slowing economic growth.
- Credit card delinquency rate is starting to rise (St. Louis Federal Reserve)
- Car loan delinquency rate is starting to increase (YCharts)
- 401(k) plan loans and withdrawals increasing (New York Times)
- Weak Consumer Sentiment (ICS: Univ of Michigan)
- Student Loan Payments to resume ($5 Billion per Month)
- Federal Spending curtailed
- Interest rates at high levels
- Weakening dollar
- S. Debt to GDP ratio 119% (St. Louis Federal Reserve)
- Averaged around a “worrisome” 60% during the Reagan years
- Previous peak was the end of WW II, when demographics were much more favorable
Contrast the rising markets when government spending increased rapidly and interest rates were zero. We are now in an opposite cycle. While we may be early on some of our decisions, we think the market regime has changed, with the potential risk of significant declines in asset prices greater than the potential gains of aggressively investing in growth. It has been over 15 years since we could create portfolios with 4% dividend yields. The current risk/reward ratio favors income-generating assets over growth-oriented investments.
Opportunities
- Stable, less consumer-driven sectors such as health care, insurance, aerospace, and defense
- High-quality fixed income
- High-yielding cash
Potential opportunities
- Foreign developed and emerging markets
- Commodities
- Gold
- Selective growth sectors
The chart below shows price declines from previous highs. Defensive sectors can potentially offer more stable (not necessarily higher) returns, with smaller losses during sharp market declines. We think this pattern is applicable under current market conditions.
Percent Off High Since 01/01/2022
We are making portfolio adjustments this week. Please contact us if you have any questions.
All charts above from YCharts.