After a continued rally in April, markets largely pulled back in May. Exceptions here were the Nasdaq, which rose, and the S&P 500, which was essentially flat. The Dow, international markets, and bond markets were down by low single digits. The primary drivers for the decline were concerns surrounding the economy, politics, and—above all—the debt ceiling.

Looking Back
The debt ceiling. For much of April, the debt ceiling confrontation dominated headlines, and worries of a government default rattled markets. Interest rates on short-term Treasury securities rose sharply on fears that they would not be paid on time, and concerns about the economic damage of a shutdown raised recession fears.

Markets consequently pulled back, with the exception of the Nasdaq. Between the excitement of the artificial intelligence sector (driven by ChatGPT) and the shocking surprise earnings report from Nvidia (which lifted the semiconductor sector), the Nasdaq and growth stocks took off. With growing concerns about the rest of the market given economic and political worries, investors shifted back to chasing growth. That said, general market conditions were difficult.

June should be different. As I write this, the debt ceiling confrontation is on the verge of resolution. The House Republicans cut a deal with the White House, which would raise the debt ceiling and is scheduled for a vote today. While passage is not guaranteed, expectations are that it will pass. If it does, it would take this issue off the table for the next couple of years and could be a tailwind for markets in June.

The economy. Another tailwind may be the economic data, which continues to beat expectations. Job growth remained strong at the start of April and is expected to be healthy for May as well. Business sentiment ticked up, and consumer confidence stayed steady. We also saw the completion of earnings season, and the results were better than expected. Overall, the economic news continued to surprise to the upside in May, suggesting that despite all of the headlines, a recession is not imminent.

Banking system health. Another piece of good news was what didn’t happen. With the failure of First Republic Bank in early May, fears of banking system risk came to the fore. Since then, there have been no further failures, suggesting that the system may not be under as much pressure as feared and that lending growth may not be as impacted as expected. Looking forward, a healthier financial system could help offset the building effects of prior Fed rate hikes.

Looking Ahead
Inflation and the markets. While much of the news was better than expected, one significant worry reappeared as inflation ticked up last month despite an expected decline. With a projected recession and inflation seemingly on a downward trend, investors expected the Fed to pause rate increases and even cut rates this year. During May, those expectations changed significantly, with markets now pricing in more rate increases and no rate cuts—which could be a headwind for the markets.

As we move into June, the key issue will be whether Congress will pass the debt ceiling deal. If not, we will see new problems and concerns, and markets will react negatively. That said, we will likely get a deal at some point during the month. And once we do, the attention will shift back to economic growth and recession.

Prospect of good news. Job growth is expected to remain healthy this month. Sentiment for both business and consumers has remained solid. Consequently, spending and investment have been healthy as well. If politics is taken off the table as a concern, the continued relatively good economic news should act as a cushion for markets in June. While the Fed remains a risk, any hikes have largely been incorporated into the market, and any hikes will be in response to continued good economic news.

The Waiting Game
The biggest headline in May was the debt ceiling, which will likely be solved shortly. Beyond that, while we have headwinds, the economy is likely to keep growing. Any change in Fed policy has already been incorporated, and we should end up with the economy and markets in a better place. In short, while May was a difficult month, it was largely for political reasons. June may be better overall.

Brad McMillan is the chief investment officer at Commonwealth Financial Network.