Markets at record levels despite persistent inflation pressure

Thoughts

• Equity markets have staged another impressive recovery, with the S&P 500^® Index breaking out to a fresh record high following a bumpy period since July. Major averages have now gained for three-straight weeks despite persistent challenges to supply chains and the labor market. A wave of technology earnings this week could shift the leadership balance that has seen value outperform growth in recent months. Technical indicators, including sentiment, momentum and breadth have recovered, with the S&P 500^® Index eclipsing the 50-day moving average, bringing the year-to-date return to 23%, and 34% over the past 12 months.
• Interest rates continue to march higher, with the 10-year Treasury yield up 0.50% since August on the looming prospect of a Fed tapering. Fed Chair Powell warned on Friday of the risk of longer and more persistent bottlenecks leading to more persistent inflation. Movement in the bond market reflect an increasing chance of a policy mistake, with short rates rising more than long rates. An announcement on tapering could come from next week’s FOMC meeting, likely reducing purchases by $15 billion a month, concluding in June. While Powell is clear to distinguish between tapering and tightening, with the Fed Futures curve now showing a 65% chance of a hike by the June meeting, up from just 15% a month ago.
• Bulls have regained control of markets on earnings optimism, but challenges from inflation and a looming shift if Fed policy remain headwinds.

News

• Inflation continues to be the primary worry of investors, with the five-year breakeven inflation rate spiking to 2.9% from 2.4% a month ago and the highest level on record dating back to 2003. A number of consumer-focused companies have passed through price increases to preserve margins, including Procter & Gamble, Nestlé, AT&T and Chipotle. Economists have an increasingly pessimistic outlook, with a CNBC survey showing a record 46% saying the economy will get worse over the next year, and 79% viewing the economy as fair or poor, the most since 2014. Nearly half believe the economy will enter a recession over the next year, up 13 points from the last time the question was asked in 2019. Just 31% say now is a good time to invest in stocks, the lowest since 2016. Two-thirds have noticed labor shortages and 60% see normal grocery items in short supply.
• Democrats have made a breakthrough on negotiations for the domestic spending bill, with House Speaker Pelosi saying they are “pretty much there now,” but did not specify a top-line number. Swing-voter Manchin reportedly is open to a total of $1.75 trillion, half of the original White House target, but more than twice the size of the rescue package signed during the financial crisis. Funding for the package is being focused on taxes for high income individuals and businesses, with a tax on unrealized gains for billionaires being discussed.
• Earnings data has been mostly encouraging, with nearly one-quarter of S&P 500 companies reporting, 85% of companies have reported better-than-expected results, and 62% seeing a positive impact on their stock price. Growth is tracking towards 33%, better than the 24% expected at the end of September. Management commentary has focused on supply chain constraints and input price pressures, offset by strong demand and the ability to pass through price to customers. Margins will continue to be a focus of investors, as mentions of “labor” on conference calls have quadrupled from the second quarter.

What to Watch

• The most active week of earnings season awaits, led by technology companies. Economic data include consumer confidence and new home sales Tuesday, durable goods Wednesday, pending home sales and the first look at third-quarter GDP Thursday, and PCE deflator, personal income & spending, and consumer sentiment Friday.