Inflation fears are an increasing challenge to equity markets

Thoughts

• Equity markets have entered a choppy period, with the S&P 500® Index unchanged since mid-April, as the tug-of-war between strong fundamentals and inflation worries continues. Following the extraordinary rally since the March 2020 bottom and particularly since November, a period of consolidation for the market is not unexpected or unhealthy. Markets are likely to continue in a saw-tooth pattern until we grow into our valuation.
• Commodity prices continue to reflect strong global demand and stressed supply chains, with the Goldman Sachs Commodity Index up 26% this year to the highest level since 2014. The year-to-date rally is consistent across energy, industrial metals, and agriculture, with gold among the few that have declined. Interest rates are controlled despite inflation expectations at the highest level in 15 years. The last time the 5-year breakeven inflation rate was at this level, the 10-year Treasury yield was nearly 5%, compared with 1.6% currently. Commodity and equity investors have been more reactive to inflation fear than bond investors, which is not uncommon.
• Investor sentiment indicators have deteriorated substantially despite indexes being within a few percent of record highs. The Global Fear & Greed Index fell to -11 on Friday compared with +22 a month ago. The put/call ratio, measuring defensive options positioning, touched 1.0 for the first time since November, but equity fund flows remain positive. Consumer sentiment fell 5.5 points to 82.8 and was below expectations due to inflation expectations, with the largest increase in expected inflation in the past decade. The rapid shifts in sentiment are an indication of the increasingly “itchy trigger finger” of investors, likely a reaction to last year’s volatility.

News

• Inflation continues to dominate the headlines, highlighted by hotter-than-expected readings on CPI (highest since 2008) and PPI, continued supply chain constraints and continued input cost pressures and price increases. The Fed officials continue to stress that the increase is transitory, but expectations for Fed funds rate hikes have spiked, with the curve now pricing in 100% chance of a rate hike by the end of 2022, despite Fed guidance that it won’t happen until 2024. Rising inflation not only challenges monetary policy, but also complicates fiscal policy and the fundamental recovery.
• The end of earnings season is shifting attention to announcements on share repurchases and dividends, as managements emerge from the uncertainty-based retention of capital in 2020. Goldman Sachs said US companies have authorized $504B in repurchases through May 7, the fastest pace in at least 22 years, even before Fed restrictions on bank buybacks expires on June 30. April’s announcements were a record-high $205 billion, more than February and March combined. IPO activity has slowed substantially from the record level in 2020, as several companies postponed listings due to the choppy market and SPAC issuance has faded. These factors support the supply/demand balance for shares, though retail investor participation declined 26% in April as the COVID-19 lockdowns are lifted.
• The outlook for a bipartisan infrastructure bill has gained steam as President Biden made clear his willingness to narrow the scope of the bill to traditional infrastructure (roads, bridges and broadband) and compromise on how it will be funded. Republicans are expected to release their revised proposal, which is expected to be $800 billion versus the previous $568 billion plan. Democrats are still planning a much larger domestic spending bill that would likely be passed in a party-line vote, addressing universal pre-K, free community college, subsidized childcare for middle-class families, expanding paid family leave and child tax credits. Funding for this plan continues to be a source of contention, as progressive and moderate Democrats are not aligned.

What to Watch

• A light week of data awaits, highlighted by housing starts on Tuesday, leading indicators on Thursday and PMI, and existing home data on Friday. The minutes from the recent FOMC meeting will be released on Wednesday and will be watched for clues on future policy.