The Pause That Catalyzes a Market Rebalance

June 13, 2023

In the latest installment of Gerry’s Journal, we share our expectations for the upcoming Federal Reserve meeting, as FOMC members continue to navigate the challenge of bringing down inflation. We also discuss several key topics including artificial intelligence and its impact on technology company valuations, the recent debt ceiling raise, and an update on continued geopolitical uncertainty involving Russia and China.

Though we certainly recognize that there are many eyes on the Fed in the short-term, we maintain that long-term financial plans are designed in contemplation of short-term fluctuations. Positioning oneself with a diversified portfolio and ample levels of near-term liquidity remains a winning strategy, regardless of market conditions or where we find ourselves in the economic cycle.

As we approach the midpoint of 2023, the financial landscape continues to evolve, influenced by a myriad of geopolitical and economic variables. At present, one of the more significant factors influencing the market is the Federal Reserve’s monetary policy. Since March 2022, the Fed has raised the Federal Funds rate by 500 basis points, while reducing the Fed’s balance sheet from an all-time high of nearly $9 trillion. The outcome sought by the Fed is reduced inflation. 1 At the time of this writing, the Federal Reserve is currently amid its scheduled June 13-14 meeting. Tomorrow at 2pm EST the Fed will announce whether it is raising interest rates, as well as provide guidance on the rate policy it will employ going forward. 2

The most recent inflation reading stood at 4.0%, a significant decline from its peak of 9.1% in June 2022.Still, the current inflation rate is double the target 2% average rate, which could cause the Fed to raise interest rates by an additional 25 basis points. It is important to remember that although the Fed targets a 2% average rate, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation modestly above 2% for some time.Our expectation, however, is that the Fed will decide to pause further rate hikes in order to assess the impact of interest rate changes so far. Whether the Fed pauses on further rate hikes for now or not, we also expect to see strong language from the Fed in its policy statement, emphasizing its continued commitment to bringing down inflation through balance sheet management and further hikes, if necessary.

Part of the Fed’s rationale for a pause may be the recognition of the strain that rate hikes have placed on the banking system. In the March edition of Gerry’s Journal, we described how the Fed’s policies created an environment that was conducive and contributed to the failure of several financial institutions, including Silicon Valley Bank, Signature Bank, and First Republic Bank. If the Fed does decide to increase interest rates, this will result in continued stress on the financial system that may in turn lead to more bank failures. Fortunately, with the bank failures that have occurred to date, the FDIC was committed to fully protecting both insured and uninsured depositors. If the FDIC continues to approach future bank failures in a similar manner, it will help to manage systemic risk and mitigate the risk of further bank runs. 5

What follows is our perspective on how investors could be impacted by the Fed’s actions, particularly in equity markets. We also explore some of the biggest drivers of market volatility today, from the rise of AI to geopolitical uncertainty.

Don’t Fight the Fed
One of the most popular activities among investors of all kinds is to predict the timing and magnitude of the next recession. Since most people do not possess the power of clairvoyance, such prognostications often end up woefully misguided. Even markets, which often harness the wisdom of the crowd, have notably poor predictive power when it comes to anticipating recessions. As Nobel laureate Paul Samuelson once quipped, “The stock market has predicted nine out of the past five recessions.” 6

The reality is that in a complicated world with multiple geopolitical and economic variables at play, trying to predict economic expansions and contractions is a fool’s errand. With that humility in mind, the best way for investors to approach economic matters is to recognize that while markets will ebb and flow, long-term financial plans are designed in contemplation of short-term fluctuations. Positioning oneself with a diversified portfolio and ample levels of near-term liquidity remains a winning strategy, regardless of market conditions or where we find ourselves in the economic cycle.

Still, there is room for optimism. Historically, capital markets have performed well when the Fed has shifted from tight monetary policy to a more accommodative stance. Over the course of 14 recent expansionary rate cycles, the S&P 500 rose by an average annualized rate of about 20%, well above its historical average.Recently, the mantra of ‘don’t fight the Fed’ has been invoked to convince investors to stay on the sidelines as the Fed continued its campaign of interest rate hikes. If the Fed decides to pause rate hikes for the time being, the same mantra could well be used to pull investors back into the markets. Although it is likely that the Fed is at, or close to, the terminal point of moving interest rates, there is the risk that the Fed will not move interest rates lower as quickly as some speculate. Accordingly, even if rates don’t go higher, we may be higher for longer.

Valuation Matters, and the Impact of AI
Recent trends in the world of artificial intelligence (AI) have led to significant excitement among investors. Large language models like OpenAI’s GPT-4, the model that underlies ChatGPT, have improved tremendously in a remarkably short period time.Recent AI buzz has been focused on the technology’s potential to improve productivity by supplementing or replacing existing workers.

Investor perception of AI likely reflects both the legitimate possibilities of the technology and the unfounded hype of the market’s animal spirits. Whatever the technology’s future, we believe that AI hype has contributed to accelerating some of the valuation imbalances currently present in capital markets.

During the first five months of 2023, gains in the stock market were overwhelmingly driven by just a few large stocks. Although the stock market rose, the majority of stocks in the S&P 500 actually trailed the index by more than 10%. 9  This year, just seven of the largest stocks in the S&P 500 have driven all the index’s positive returns. 10  This valuation disconnect has only increased since Nvidia announced exceptional earnings on May 24th, drawing more investors to the AI bandwagon. 11  This year’s stock market rebound can mainly be attributed to the performance of large stocks in general, and technology stocks in particular.

Since many technology companies are growth companies that benefit the most when monetary policy shifts from tight to accommodative, the technology sector as a whole already began to rally due to expectations that the Fed will pause rate hikes. 12  AI hype has only contributed to driving valuations higher, leading to the present disconnect with prices.

While we don’t want to downplay the scale of AI’s potential disruption, our analysis is that the market has gotten a bit ahead of itself. AI has the potential to be transformative, but the current level of excitement has propelled the valuations of a few companies higher than can be justified by the fundamentals. It is not our expectation that the mega cap tech names racing ahead will come crashing down.
Rather we would anticipate a period of consolidation for those companies during which earnings may catch up to price. We also anticipate that unless our economy drops into a deep recession, it is likely that other sectors will begin to participate in a near-term rally as well.

Debt Ceiling – The Crisis That Wasn’t
Amid an uncertain time for markets, we can now take stock of one potential crisis that was averted. Despite investor uncertainty about the prospects of a U.S. government default, and the possibility of a downgrade by the ratings agencies, the drama recently came to an underwhelming conclusion.

On June 3rd, President Biden signed the bipartisan Fiscal Responsibility Act of 2023, raising the debt ceiling and avoiding a potential default. 13  The best that can be said about the debt ceiling deal was that it avoided imminent catastrophe.

The deal itself pushes off the debt ceiling question until the end of 2024, at which point investors may find themselves living through another debt-ceiling crisis reminiscent of 2011, 2013, and now, 2023. 14  The most recent episode failed to answer lingering constitutional questions about the government’s authority to repay debt despite debt ceiling limits, questions which will surely feature in future debt ceiling debates.

Geopolitical Uncertainty – Russia and China
The Russo-Ukrainian war shows no signs of coming to a near-term conclusion, as Ukraine recently launched a counterattack against Russian forces. 15  While the greatest impact of the war continues to be the humanitarian disaster it represents, we are actively monitoring the situation for way it could impact investors.

An end to the war could have a significant impact on commodity markets, including wheat, of which Ukraine is a large producer. 16 Moreover, while the West has largely weaned itself off Russian energy, the country is such a large producer of oil and natural gas that the conclusion of the conflict is likely to lead to significant volatility in energy markets. 17

Aside from the war in Ukraine, the biggest source of geopolitical uncertainty continues to be competition between China and the West. This competition has direct implications for global markets, with ‘de- risking’ initiatives in America and Europe seeking to maintain general trade ties with China, while reshoring and regulating sensitive industries. 18

Tensions around Taiwan remain elevated, although somewhat down from the peak we saw over the past year. The threat to Taiwan, and, by extension, to the global semiconductor manufacturing industry, remains high. While we are hopeful that the relationship between the US and China will remain stable amid the current evolving trade environment, we continue to believe it is prudent to tactically underweight investment exposure to China.

Although we believe that the Fed is set to pause its interest rate hikes and that such a pause will likely be well received, we also acknowledge the inherent uncertainty surrounding the Fed’s actions and the market’s reactions. We also caution against believing that elevated interest rates being paid on cash and cash equivalent investments are here for the long term. To that end, we continue to believe that maintaining a well-diversified portfolio as part of a sound financial plan remains the best strategy for navigating periods of uncertainty.

Markets will shift and change, but one thing that will not change is our commitment to you and your family’s financial goals. If you’d like to review your current asset allocation and wealth management strategy, or if you’d just like to discuss the current state of the markets, we invite you to connect with our team for a meeting.

The views contained in this presentation represent the opinions of GYL Financial Synergies, LLC as of the date hereof unless otherwise indicated. This and/or the accompanying information was prepared by or obtained from sources GYL Financial Synergies, LLC believes to be reliable but does not guarantee its accuracy. The report herein is not a complete analysis of every material fact in respect to any security, mutual fund, company, industry, or market sector. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. This document contains forward-looking statements, predictions, and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements. Past performance does not guarantee future results. CAR20230613GYLGJ

1 Federal Reserve Bank of St. Louis, Federal Funds Target Range – Upper Limit (here)
2 Federal Reserve Bank of St. Louis, Total Assets (here)
3 U.S. Bureau of Labor Statistics, Consumer Price Index (here)
4 Federal Reserve, Why does the Federal Reserve aim for inflation of 2 percent over the longer run? (here)
5 FDIC, FDIC Acts to Protect All Depositors of the former Silicon Valley Bank, Santa Clara, California (here)
6 Newsweek, 1966 (print)
7 Strategas via CNBC, This chart of booming returns following rate cuts shows why investors say, ‘Don’t fight the Fed’ (here)
8 Wired, How ChatGPT and Other LLMs Work—and Where They Could Go Next (here)
9 Ned Davis Research.
10 Reuters, Top-heavy and ultra-narrow – Wall St needs to bulk out (here)
11 Reuters, Nvidia shares soar nearly 30% as sales forecast jumps and AI booms (here)
12 Bloomberg, Citi Quants Say the AI-Driven Tech Rally Has Legs (here)
13 The White House, Press Release: Bills Signed: H.R. 346, H.R. 3746 (here)
14 The Conversation, A brief history of debt ceiling crises and the political chaos they’ve unleashed (here)
15 Reuters, Ukraine reports ‘heavy combat’ after Putin says offensive has begun (here)
16 Reuters, Russia’s war may deprive world of three Ukrainian wheat harvests, agriculture minister says (here)
17 New York Times, Why Russian Oil and Gas Matter to the Global Economy (here)
18 The Economist, The end of Western naivety about China (here)