The S&P 500 hits record high despite surging inflation

Thoughts

• The S&P 500® Index begins the month at a fresh record high after being stuck in a narrow trading pattern for two months. Technology and other growth sectors have reemerged as the market leaders, with the NASDAQ less than 1% below a record high and showing gains in four straight weeks. This shift is seen as a reaction to lower interest rates, improving valuations and the likely peak in earnings growth in the next few quarters have many predicting a resurgence of the growth leadership that drove much of the post-financial crisis bull market and a stall in the pro-cyclical “reopening” trade. The technology and quality growth space often act as the “comfort blanket” for investors looking to add exposure to equities.
• The bond market staged an impressive rally, bringing the 10-year Treasury yield to 1.46%, the lowest level since February. The glass-half-fool mindset is focused less on the current level of inflation, but rather on the likelihood that the pace is peaking. This message has been consistently reinforced by Federal Reserve officials, who are likely to reiterate that message this week. Other factors include short-covering and pension buying. Credit spreads collapsed to near record lows and the Fed’s reverse repo program is at record highs, reflecting an enormous amount of liquidity in the system and optimism of investors. Among the primary risks to the bond and stock market is the potential for inflation to remain stubbornly high, challenging the “transitory” nature of the reading and raising the risk of a Fed policy mistake. Investors need to remain vigilant, as much of the elevated inflation is temporary, a portion is more structural.
• Tremendous liquidity in the global capital markets has resulted in elevated valuations in nearly all asset classes, including equities, bonds, commodities, and real estate. While equity market valuations get the most attention, they are arguably the least extended among the asset classes.

News

• The FOMC meets this week, and much of the focus will be on a discussion around tapering of asset purchases from the current $120 billion per month pace. Economists expect a formal discussion sometime in the third quarter, with actual tapering not expected until next year. The Fed’s “dot plot” will get an update, with debate on whether it will continue to show no rate hikes through 2023 given the shift in market expectations to an earlier date.
• The G7 meeting has not driven volatility in the market, as the leaders agree that continued fiscal stimulus is necessary and the global minimum tax should be at least 15%. The primary source of tension appeared to China, as President Biden sought to build consensus to counter China’s influence in the world. The joint statement asked China “to respect human rights and fundamental freedoms, especially in relation to Xinjiang and those rights, freedoms and high degree of autonomy for Hong Kong,” though the U.S. was unsuccessful in formally condemning forced labor practices. This statement is not expected to cause any immediate action. Critics of the summit note that the policy measures from the summit were not new and lacked sufficient detail to be material.
• Inflation data continues to run at historic levels, with May headline consumer price inflation up 5.0% from a year ago, ahead of the 4.6% consensus and the highest level since 2008. Core CPI (excluding the volatile food and energy categories) jumped 3.8%, above the 3.4% consensus and the largest reading in 29 years. Used car prices were the largest factor in the print, up 7.3% from April, though it was a slight deceleration from the 10% reading last month. Other drivers were airfares, transportation services, and apparel, though shelter (30% of CPI), health care, and rent were modest. Investors shrugged in reaction, as the report was viewed as transitory and a reaction to the collapse in inflation in the year-ago period as the economy was shut down.
• A group of 10 Democrat and Republican senators reached a tentative agreement on a $974 billion infrastructure plan that focuses on physical infrastructure such as roads and bridges and would not raise taxes. House Speaker Pelosi noted the bill would be a hard sell to her party, though she sees the possibility of passing the bipartisan plan and following with a second plan passed through reconciliation as Democrats have “no intention of abandoning” the rest of the vision.

What to Watch

• Inflation remains in focus this week with the release of PPI on Tuesday. Other important data includes retail sales and industrial production on Tuesday, housing starts on Wednesday, and leading indicators on Thursday. The conclusion of the FOMC meeting and the press conference is on Wednesday.