It was a bad week for both stocks and bonds with much of the damage coming on Friday. The major U.S. stock indexes fell around 5% to 6%, The S&P 500 and the NASDAQ posted their ninth negative weekly result out of the past ten. The week’s decline in the prices of government bonds accelerated after the release of Friday’s inflation report, sending the yield of the 10-year U.S. Treasury bond higher, to 3.16%. I have broken down this week’s update using quotes from someone much wiser than I, Sun Tzu.
Vexing perfectly describes how the Federal Reserve feels about inflation. Surging energy and food prices drove inflation to an annual rate of 8.6%, the highest since December 1981. Last month’s figure is up from 8.3% in April. The Federal Reserve raising rates can temper consumer-discretionary demand. However,rate hikes generally do not impact global commodity prices or the demand for consumer staples, like food and energy. To judge if the rate hikes are working you need to look at core inflation (excluding energy and food). Core inflation rose 0.6% on a month-to-month basis in May. That was the same rate as in April. Core inflation needs to continue to slow for the market to rally. The hopeful piece of the inflation report is that there was a modest decline in year over year core inflation, from 6.2% to 6.0%. This was driven in part by better prices for medical care and transportation services. Many economists anticipate areas like used- and new-car prices and airline fares, which were still high, could trend lower in the months ahead. If core inflation dropped from 6% to 4.5% on a year over year basis, the Fed would likely be content and would pause on further rate hikes. A rate hike pause would cause stocks to rebound in a meaningful way. There is a case to be made that this could happen by the end of the end of this year.
There has been much made of a looming recession. In fact, the markets have priced in a 70% chance of recession. A recession is defined as two consecutive quarters of negative Gross Domestic Product (GDP). A second negative read on GDP would be a declaration of recession. Would it really be something to be afraid of? When you hear the word recession you don’t think about calendar quarters of GDP. You likely think about the US economy struggling, people losing work, and companies making fewer sales. I would contend that if we do slip into a recession it requires no battle, to paraphrase Sun Tzu. Why? The danger we all think about when we think recession is not present. The U.S. economy began the year from a position of strength:
- A strong and healthy consumer, and the numbers still bear that out.
- A solid labor market, numbers might be softening a little but are still much better than what you would typically see at the start of a recession.
- Resilient corporate earnings, S&P earnings are growing at 9% and forecasted to continue growing. Corporate insiders have been purchasing at a faster rate over the last few weeks while insider selling has waned. Presumably those deemed insiders within a corporation should have a better sense of the outlook. If insider buying has picked up it’s because they think the market has miss priced their company’s stock.
The masses are usually wrong. Warren Buffet has made his money by buying while others are selling. I am not saying go and take all your money out the bank and invest in the market. What I am saying is we have a lot of fear now. The monthly gauge of U.S. consumer sentiment fell to the lowest level ever recorded by the survey, which dates to the 1970s. Times of extreme fear tend to be good buying opportunities so hold on to your growth investments and continue to invest systematically in your retirement plan. You will thank yourself later for not abandoning your plan.
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