The much-celebrated stock-market rally of 2023 finally came to a halt last week as signs emerged that a surge in buying sparked by the “fear of missing out” has run its course. While many analysts believe that the rally isn’t over yet, they caution that it could face significant challenges in the coming weeks due to a dip in market liquidity.
Michael Arone, chief investment strategist for the U.S. SPDR Business at State Street Global Advisors, warns that a “trifecta” of events are sapping liquidity from the market. According to Arone, quarterly estimated corporate taxes due from June 15 are taking liquidity out of the financial system by drawing payments from bank demand deposits and sending them to Treasury. He also says that Treasury will continue to issue T-bills to rebuild the depleted Treasury General Account which is expected to add to the drain on liquidity.
Arone believes that around 50% of the demand is coming from money-market funds in the Federal Reserve’s reverse repo facility while the other half is being withdrawn from bank deposits.
To compound the situation, quantitative tightening by The Fed will also drain $55 billion from the system over the coming weeks as the central bank allows Treasuries and mortgage-backed securities to roll off its balance sheet without reinvesting the proceeds.
These factors combined suggest that it may take some time for the stock market rally to regain momentum and continue on its upward trajectory. While we don’t think it’s over, it remains to be seen how long it’ll take before investors can get back on track.
S&P 500 Index Falls: Is the AI Boom Here to Stay?
The S&P 500 index had an abrupt end to its streak of weekly gains, dropping 1.4% last week and settling at a 14-month high alongside the Nasdaq Composite. Nasdaq also pulled back 1.4%, while the Dow Jones Industrial Average shed 1.7% – all three major indexes suffered the biggest weekly decline since mid-March.
Many analysts see the setback as long overdue, given the 15% rally off its 2023 closing low, led by a handful of megacap tech stocks, supercharged by a frenzy for AI-related plays. “The rapid move in equities has created overbought conditions, and arguably has gone ‘too far too fast,'” warns Mark Hackett, chief of investment research at Nationwide.
As we approach second-quarter earnings season, however, fundamental picture is substantially better than feared., adds Hackett. Despite the recent pullback, Wall Street seems to remain optimistic that the AI boom shall persist.
Meanwhile, much of the buying that helped fuel the surge last month appeared to come from fund managers and other professional investors who missed out on the rally – a phenomenon known as “pain trade,” says Huw Roberts, head of analytics at research platform Quant Insight. Fear of missing out (FOMO) is another reason for the recent surge in equities.
Money Managers Fear Falling Behind on Tech Stocks
For money managers, missing a fixed calendar point can cost them dearly in terms of disappointed clients and bosses. As the month, quarter, and first half come to a close, managers who are underweight on tech are finding it increasingly difficult to justify their fees.
While the S&P 500 has seen a rally on the back of improving macro fundamentals, it has outpaced the improvement of the macro backdrop. This catch-up buying has largely run its course.
According to Quant Insight’s macro-based model, the fair value for the S&P 500 is near 4,350, slightly below its current level. This is expected to cause near-term consolidation.
To resume the rally, market participants are looking for a resolution to the debt-ceiling showdown and hoping for a prolonged pause in interest rate hikes by the Federal Reserve. However, with Chair Jerome Powell reiterating that two more quarter percentage point rate hikes are in the pipeline, this looks unlikely.
Will Interest Rate Hikes Bring Recession Closer for the U.S. Economy?
Investors are becoming increasingly concerned about interest rate hikes and their potential impact on the US economy, with many believing they could bring forward the timeline of recession, or make things even worse. It’s clear that the market needs clarity and guidance, and this is especially true following recent warnings from analysts at JPMorgan that unknown unknowns could drag shares lower.
The wider market has been showing some signs of improvement in recent weeks, but the equal-weighted S&P 500 remains up just 3.4% so far this year, compared to the market-cap weighted index which has gained over 13%. To sustain a broadening out of the rally, gains are necessary across cyclically oriented stocks, small-cap stocks, and value stocks, among others. These areas of the market have lagged significantly behind the tech-oriented rally and it will be important to see them catch up if the stock market is to continue its upward trajectory.
State Street does, however, see room for stocks to extend their rally later this year, despite the bumpier path they may face in the near term. The week ahead holds several important events and although there are no major economic data releases set for that period, there will be a lot of attention paid to Friday’s personal-consumption expenditures index for May – which is expected to include the Fed’s favored inflation measure.
While there is a lot of uncertainty in the markets right now, clarity on economic outlooks might just provide a much-needed boost.