A Lehman’s moment in weeks? – Damien’s Market Update – May 2023

4 min Read Published: 16 May 2023

Welcome to the latest episode of my monthly YouTube show where I discuss what is happening in investment markets and what to look out for. This month I talk about how the impending decision on the US debt ceiling is likely to impact investment markets.

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Abridged transcript - Damien's Market Update - May 2023

I ended last month’s update, which was also recorded mid-month, I highlighted how investors were finally starting to take notice of assets that had been unloved over the last year - which included gilts, bonds, gold, technology stocks and European stocks.

As we entered May, UK and European stock markets continued to outperform their US peers.

The strengthening pound against the US dollar has played a significant role in the outperformance of UK stocks versus US stocks ever since the banking crisis started in early March. Market expectations of the UK avoiding a recession and the Bank of England having room to raise interest rates for a longer period helped strengthen the pound. Meanwhile, belief that the US Fed Reserve might have to pivot sooner, in part as result of the banking sector chaos and start cutting interest rates to support its economy, caused the dollar to weaken.

In terms of European equities, their strong performance continued, with the French CAC 40 setting a new all-time high, as European stocks continued to benefit from China's economic reopening and attractive stock market valuations.

If we focus on US stock markets for a moment, while the pound's strength made US equities and bonds less attractive, there were concerns as well about the lack of breadth in the 2023 rally which is still the case. The S&P 500 is a cap-weighted index and Microsoft and Apple now account for around 13% of the index. The dominance of these two stocks mean they are responsible for a significant portion of the index's rally this year. However, in late April signs began to emerge that US tech companies were finally struggling to lift the broader market higher.

April also marked the start of the corporate earnings season. Although broadly, profit margins fell less than expected, the market eagerly awaited the big tech earnings in the final week of April and the first week of May. In the end Microsoft, Alphabet (Google's parent company), Meta (formerly Facebook) and Apple surpassed analysts' expectations, resulting in a surge in their stock prices.

This positive performance lifted the S&P 500 and the tech-heavy Nasdaq 100, providing a temporary cause for celebration. But soon concerns regarding the viability of several regional US banks resurfaced. First Republic, a U.S. regional bank, experienced a significant loss of deposits, leading to a decline in its stock price. After failed rescue attempts, J.P. Morgan ultimately acquired the struggling bank.

First Republic joined the growing list of emergency bank acquisitions, which were in part caused by aggressive interest rate hikes from central banks, particularly the US Federal Reserve. It appears that central banks remain focused on taming inflation, even if it means collateral damage to the banking sector.

We are now halfway through May and the market has already navigated a number of potential banana skins. The European Central Bank (ECB) and the US Federal Reserve and the Bank of England made their latest monetary policy decisions. All three events passed without causing too much volatility with them each raising their benchmark interest rates by 0.25%.

But there is a suggestion of a potential divergence between the major central banks, in terms of future interest rate decisions, which could have a significant impact on investment markets. The ECB hike of 0.25% represented a reduction in the rate of interest rate increases compared to previous announcements. The market is already pricing in a Fed hiking pause while the Bank of England is predicted to continue to raise interest rates in the coming month to near 5%.

So in summary, bond yields remain below their March highs, reflecting lingering recession fears, while the banking crisis continues to cast a shadow as central banks persist in raising interest rates. While stock markets continue to prove resilient, especially in Europe, despite May historically marking the beginning of a seasonally weak period for stock markets. Not so far this year apparently.

The pound has also hit a new one-year high of $1.26 against the US dollar. But there are now signs that the recent strength in the pound could be cracking (with the pound just below $1.25 as I write). So we will have to keep an eye on how currency markets behave in the coming weeks, but if the pound does change trend and head lower, it will have a significant impact on UK investors' returns, with overseas holdings gaining more appeal thanks to a boost from such a currency move. Essentially the opposite of what we’ve seen since mid-March.

But an even bigger cloud is on the investment horizon which is the US debt ceiling. The US government is facing the possibility of running out of money in the coming weeks if it doesn't raise the debt ceiling, which is the limit on the amount of money the government can borrow to pay its bills. The debt ceiling has to be periodically raised or suspended by Congress to allow the government to borrow more. Currently, the debt ceiling stands at around $31.4 trillion and Democrats and Republicans are engaged in political brinkmanship in trying to reach an agreement on how to raise the debt ceiling. If the debt ceiling isn't raised, the US could default on its debt, leading to major economic damage. As soon as 1st June, the government would be unable to pay federal and military employees, pensions, and various agencies would shut down. But the implications to financial markets could be significant with some analysts predicting stock markets would crash and the US economy would contract. Some are likening it to a potential Lehman's moment for investors.

In this week’s 80-20 investor newsletter I’ll go over in more detail the dire predictions and the assets that may be best placed to ride the storm if no agreement is reached, which admittedly is the least likely outcome. But nonetheless, the relatively quiet markets we’ve seen over the last few weeks could be about to change.