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Investors will head to the Federal Reserve’s monetary policy meeting next week as the “Goldilocks” market environment that has helped lift stocks to record highs and tame bond selling is being tested by rising inflation.
Stocks have risen steadily in recent weeks and are now standing at new highs, extending a rally that has seen the S&P 500 (.SPX) index rise 13% this year and nearly 90% from its March 2020 low. US government bonds have also risen. After being sold in the first quarter, with the benchmark 10-year Treasury yield, moving inversely with prices, recently at 1.46%, about 30 basis points lower than its first-quarter highs.
Some of these gains were based on the Fed’s assurances that rising inflation would not last long enough to warrant a faster-than-expected end to easy money policies. Signs that the Fed is growing less confident in those assumptions could destabilize stocks, which have benefited from quantitative easing, and hurt bonds, as higher prices erode the value of long-term debt.
Investors will “look for signs that the Fed may think inflation is more permanent,” said Michael Aaron, chief investment analyst at State Street Global Advisors.
The Federal Reserve confirmed that it has the tools to deal with accelerating inflation. The central bank may open discussion at its Tuesday and Wednesday meeting about when to start unwinding its $120 billion per month government bond purchases, though most analysts don’t expect a decision before the Fed’s annual Jackson Hole, Wyoming, conference in August. Read more
At the moment, some investors seem to be leaning towards the way the Federal Reserve thinks about inflation. Stocks on Thursday shrugged off data showing consumer prices rose in May at their fastest annual pace in 13 years, with Standard & Poor’s setting a new record. By contrast, a much higher-than-expected inflation number last month triggered a sell-off in stocks. Read more
Regardless of the strong inflation numbers, recent data have provided snapshots of an economy strengthening but not seeming to be close to overheating. Employment, for example, is still about 7.6 million jobs below its February 2020 peak while the last monthly report was below economists’ estimates. Read more
“We’re making progress, but the economy isn’t a full blown and a fast-moving train where the Fed has to take action,” said Chris Gallebo, chief market analyst at Putnam Investments. “This puts us in the ‘Goldilocks’ scenario.”
However, others are concerned that markets are becoming complacent about inflation and other risks that could derail the current rally, from potentially high taxes to extreme economic growth rates.
A banner is seen on Wall Street outside the New York Stock Exchange in the Manhattan borough of New York City, New York, US, April 16, 2021. REUTERS/Carlo Allegri
Analysts at BofA Global Research on Friday identified a number of reasons why inflation is more sustainable than many expect, including second-tier indicators such as the National Federation of Independent Business Survey of Small Businesses that show price pressures are transferring to customers.
The list of excuses for temporary inflation is getting longer. “The risks of high and sustained inflation are increasing,” wrote analysts at Bank of America.
More broadly, bullish sentiment among retail investors has been above its historical average of 38% for 25 of the past 30 weeks, according to the American Association of Retail Investors. Meanwhile, the bearish sentiment is below its historical average of 30.5% for the 18th consecutive week.
“At current levels, pessimism remains extraordinarily low,” the association said on its website. “Historically, below-average readings have been for bearish sentiment followed by below-average six- and 12-month returns for the S&P 500.”
Bulls can point to a lot of reasons why stocks remain strong. Most investors believe the Fed will only start reducing its bond purchases in late 2021 or early next year. Bets in the eurodollar futures markets show that investors believe the Fed will start raising its benchmark interest rate in late 2022.
Rising estimates of corporate earnings growth are also supporting stocks. S&P 500 earnings are now expected to jump 36% this year, compared to April’s estimate of 26% growth, with profits expected to rise another 12% in 2022, according to Refinitiv IBES.
That hasn’t stopped some of the world’s largest banks, including Morgan Stanley, from warning in recent months that the market is poised for a sharp downturn. Read more
Matthew Miskin, associate chief investment strategist at John Hancock Investment Management, continues to favor stocks over bonds, favoring the healthcare, industry, technology and communications services sectors.
“We are expecting some volatility and we have been saying so, and yet the declines were met with very strong demand,” he said.
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