Stocks sink on hotter than expected inflation data

You need to know the market’s going to go down sometimes. If you’re not ready for that, you shouldn’t own stocks. And it’s good when it happens. – Peter Lynch 

Hopes that inflation may have peaked were dashed on Friday when the consumer price index (CPI) for May came in hotter than expected, causing the major stock averages to tumble that resulted in losses of about 5% for the week. The Dow Jones Industrial Average has now been down for 10 of the last 11 weeks while the S&P 500 Index and the Nasdaq Composite Index have fallen in 9 of the past 10 weeks as inflation continues to get worse. The May CPI rose 8.6% year over year, the highest level since 1981, as the headline number that includes both food and energy prices jumped 1% for the month. Even though average hourly earnings rose for the month, real wages fell when inflation was taken into account. The data likely ensures that the Federal Reserve will raise interest rates by at least 50 basis points (a basis point is one hundredth of one percent) in June and July and possibly again in September to bring down inflation. The only good news last week was that China removed Covid-related restrictions and was making progress in reopening its economy after the shutdowns. The country could be close to operating at near-full capacity within a month, which could boost the economy and ease supply chain disruptions. In the U.S., mortgage demand hit its lowest level in 22 years due to rising interest rates and lack of available listings. The Atlanta Federal Reserve also lowered its forecast for second quarter GDP growth to just 0.9% and the World Bank cut its global growth forecast as well. Oil prices continued their upward climb, too, as West Texas Intermediate crude oil rose to over $120 a barrel, causing gas prices to be up nearly 50% since last year. Not only did stocks sink after the May inflation data was released, but bond prices fell and yields rose as the 2-year Treasury yield jumped to 3.06% while the 10-year Treasury yield climbed to 3.16%.  With the Fed likely to remain aggressive in its efforts to reduce inflation, the odds that it can do so without causing a recession are becoming less probable.

Last Week

The preliminary University of Michigan consumer sentiment index for June fell to 50, which was much lower than expected and the lowest level ever recorded by the survey as the rising cost of food, gas and other essentials weighed on consumers. Weekly jobless claims were 229,000, higher than the estimate of 210,000, and the highest level since January.

The European Central Bank (ECB) raised its benchmark interest rate for the first time in 11 years and announced that it will raise it by 25 basis points at its July meeting and again in September as annual consumer inflation hit a record high in May.

For the week, the Dow Jones Industrial Average fell 4.6% to close at 31,392 while the S&P 500 Index lost 5.1% to close at 3,900. The Nasdaq Composite Index dropped 5.6% to close at 11,340.

This Week

The May producer price index (PPI) is expected to increase nearly 11% while retail sales in May are expected to increase only modestly and be less than in April. Leading economic indicators for May are forecast to show a modest decline after a similar drop in April. May housing starts are expected to approximate numbers posted in April.

The Federal Open Market Committee (FOMC) meets this week and is expected to raise the federal funds rate by 50 basis points.

There are just a handful of quarterly earnings reports this week and the most notable of these are Oracle, Adobe and Kroger.

Portfolio Strategy

The Federal Reserve’s two-day meeting is undoubtedly the most important event this week, especially coming after the hotter than expected consumer price index (CPI) that was released on Friday. Most economists and investment strategists expect the Fed to raise the federal funds interest rate by a half of one percent in keeping with its previous guidance, although some fear a 75-basis point increase after the surprisingly high CPI number. However, the Fed has previously emphasized that it does not want to surprise the markets but, instead, manage expectations. What may be more important to investors is what Federal Reserve Chairman Jerome Powell says in his press conference after the meeting in terms of the Fed’s plan for future interest rate hikes. The forecast for the federal funds rate at year-end has risen to about 2.70% from about 1.90% just three months ago. While the Fed wants to raise interest rates to bring down high inflation, it doesn’t want to be too aggressive and cause the economy to slide into a recession. It’s also important to watch the action of the bond market as Treasury yields rose after the release of the CPI report and the yield curve (the difference between short-term bond yields and long-term bond yields) flattened. The difference between the yield on the 2-year Treasury (3.06%) and the yield on the 10-year Treasury (3.16%) was only 10 basis points. If the yield on the 2-year were to move above the yield on the 10-year, the yield curve would be inverted, suggesting that the odds of a recession have increased.