Equity markets climbed in May. US stocks continued to lead the way, both large and small. Developed foreign markets nearly kept pace, while emerging market stocks were a material laggard. Much of the excitement in public and private markets has continued to be centered on artificial intelligence and the associated investment cycle. While the investment cycle is real, the future economics of artificial intelligence and the returns on current and future investment are still unknowable. At this point many return predictions are possible, but the probabilities of such predictions are highly uncertain, and the range of potential outcomes seems very wide. Meanwhile, the bar for surpassing the most optimistic predictions, and the market’s implied probability of meeting or surpassing those predictions, keeps grinding higher. Whether or not the exuberance has been rational remains to be seen.
In the fixed income market, interest rates ticked lower while credit spreads have remained historically tight. This tightness is, in some ways, surprising while in other ways it makes more sense. Higher borrowing costs should make leverage riskier and push more heavily indebted borrowers into distress, either because the costs have ticked up in real-time or they need to refinance maturing borrowings at a significantly higher rate. To a certain extent this has happened, as bankruptcies have risen in number but have remained relatively small in size. However, the need for capital among private sector borrowers is lower and in relatively shorter supply. The US government is running large budget deficits (in an economic expansion, in “peacetime”) that need to be financed regularly. Thus, the supply of treasuries is increasing meaningfully while the supply of bonds for creditworthy borrowers has not kept pace. The supply/demand imbalance seems to have kept spreads tight until there is a reason, potentially a crisis or recession, for them to widen.
The backdrop on the economy has plusses and minuses. It is growing in nominal terms but less so in inflation-adjusted terms and seems capable of muddling through. The labor market appears to be normalizing but holding up. The inflation fight seems to be two steps forward, one step back. It remains to be seen if inflation can get back to the Fed’s target and, if so, for how long. The Federal Reserve is running a tighter monetary policy that raises borrowing costs on consumer finance, riskier borrowers, and the US government. The Federal Government, by nature of the large deficit spending, is running an expansionary fiscal policy. So far, the forces of the government’s fiscal policy seem to have dominated the Federal Reserve’s monetary policy.
Ironically, a large part of the budget deficit increase is due to the government’s own borrowing costs, and rate cuts may result in less expansionary policy from the US government. Absent rapidly falling rates, we struggle to see how the expansionary fiscal policy meaningfully reverts as the structural bias may be for more deficit spending as a percentage of GDP rather than less. Due to this setup, it is possible that inflationary biases in the US economy are structurally stronger than the deflationary ones from the pre-Covid era.
