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Stocks rally despite hawkish comments from the Fed

Don’t think that you know more than the market. No one does. And don’t act on insights that you think are your own but are usually shared by millions of others. – John Bogle 

After falling for three consecutive weeks, all the major stock averages rebounded last week to post solid gains, ranging from 2.7% for the Dow Jones Industrial Average to 4.1% for the Nasdaq Composite Index. The S&P 500 Index had fallen for seven straight trading days and had lost nearly 9% during that stretch, but it also rallied last week despite renewed commitment from the Federal Reserve that it would continue to raise interest rates to combat inflation. With second quarter earnings season essentially over and very little economic data released last week, investors focused on comments by Fed officials and the Beige Book, a summary of current economic conditions across all the Fed’s twelve districts. On Wednesday, Fed Vice Chair Lael Brainard reiterated the Fed’s tough stance on inflation but also cited the risks involved in tightening too much. The financial markets are currently pricing in about a 90% chance of a 0.75% rate hike when the Fed meets later this month. The next day Fed Chairman Jerome Powell echoed those sentiments and said that the Fed would tighten monetary policy until inflation reaches its 2% target. He also cautioned against prematurely easing monetary policy, which investors had hoped for the previous week. The Fed’s Beige Book did not contain any surprises, either. It showed that economic activity was mostly unchanged since early July and that the outlook for future economic growth remained weak. Labor market conditions also remained tight and price levels remained highly elevated even though there was some moderation in the rate of increase. Despite the high inflation, it showed that consumer spending remained relatively stable. Probably the biggest reason for the strength in the stock market last week was simply the fact that it had become too oversold after declining to levels that appeared attractive to investors. The S&P 500 had rallied to nearly 4,300, its 200-day moving average, before dropping to approximately 3,900, a level that offers support for the index. While forecasts are difficult to make, the most likely scenario for the market is to be range-bound between these two levels over the near-term.

Last Week

The August ISM services sector Purchasing Manager’s Index (PMI) was stronger than expected and comfortably in expansion territory. The weekly jobless claims were 222,000, down 6,000 from the previous week, making it the lowest number of claims since the week ending May 27th.

The European Central Bank (ECB) raised its benchmark interest rate by 75 basis points (a basis point is one hundredth of one percent) as expected and forecast additional rate hikes to bring down high inflation. Inflation has been fueled by soaring energy prices caused by Russia’s invasion of Ukraine and ongoing supply chain issues.

For the week, the Dow Jones Industrial Average rose 2.7% to close at 32,151 while the S&P 500 Index climbed 3.7% to close at 4,067. The Nasdaq Composite Index jumped 4.1% to close at 12,112.

This Week

The consumer price index (CPI) for August is expected to increase slightly over 8% year over year, less than in July, while the producer price index (PPI) is forecast to rise nearly 9% year over year, also less than in the previous month. August retail sales are expected to increase slightly after being flat in July. The University of Michigan consumer sentiment index for September is also forecast to be slightly higher than in August.

There are only five companies scheduled to report second quarter earnings this week and the most prominent of these are Oracle and Adobe.

Portfolio Strategy

Inflation data will take center stage this week with the release of both the August consumer price index (CPI) and the producer price index and both are expected to ease slightly. Any decline in prices will be welcome news for investors and consumers, but the Federal Reserve will probably still raise the federal funds interest rate by 75 basis points when they meet on September 20th and 21st. However, there is growing evidence that inflation may have peaked and will gradually be headed lower. Oil prices have fallen to about $85 a barrel and gasoline prices, which historically have tracked the consumer price index in the past, have also declined considerably. Commodity prices for lumber, copper, agricultural products and metals and minerals have also dropped significantly in recent months and should begin to show up in the inflation data. The most recent ISM manufacturing report showed weakness in prices being paid and suggested that inflation expectations had also declined. Housing data lately has been particularly weak as existing home sales, new home sales and mortgage applications have dropped as mortgage rates have climbed to nearly 6%. Supply chain disruptions, which have plagued the global economy during the ongoing pandemic, have also begun to recede. China’s economy, which is the second largest in the world, has forced many cities to go on lockdown due to Covid-19, which has affected consumer spending and slowed economic growth. All these data points are deflationary and could give the Federal Reserve reasons to be less aggressive in raising interest rates. With quantitative tightening or the shrinkage of the Fed’s balance sheet expected to continue, maybe that will be enough to reduce high inflation and achieve a soft landing.