S&P 500 edges higher despite renewed Fed rate hike fears

Everyone has the power to follow the stock market. If you made it through fifth grade math, you can do it. – Peter Lynch

After declining for three consecutive weeks, the S&P 500 Index managed to eke out a modest gain last week despite renewed fears that the Federal Reserve may raise interest rates at their meeting in June. Weak first quarter gross domestic product (GDP) growth and a lackluster employment report for April seemed to convince investors that there would only be one rate hike this year and it would not occur until December. All of that thinking changed, however, with the release of the Federal Open Market Committee (FOMC) minutes from their April meeting. The minutes revealed that most Fed officials are ready to lift the federal funds rate in June if incoming data warrants such a move. In other words, if growth accelerates in the second quarter, the labor market strengthens and inflation increases toward their 2% target, then there is a strong possibility that a rate hike will occur. As the Fed has emphasized all along, they will be data dependent in making their decision but will also be mindful of communicating their intentions early to prevent a surprise for the markets. To make matters worse, three Fed presidents echoed the same sentiment in separate speeches last week. All three said that the June Fed meeting was definitely “live” and that not only was a Fed rate hike possible in June, but that there might be two more this year. This news added insult to injury and stocks tumbled, losing more than 2% by Thursday. Strong earnings by Wal Mart, though, which beat quarterly earnings estimates on better than expected same-store sales, proved to be the catalyst the market needed to reverse the losses and send stocks higher. Other retailers such as Home Depot and TJX Companies also posted strong results and the good news, coupled with the strong April retail sales data released the previous week, seemed to reassure investors that there was still growth in the economy. For the most part, economic data released last week confirmed this fact, but the focus for the next three weeks will be on Fed Chair Janet Yellen, who has two speaking engagements prior to the FOMC meeting on June 14th and 15th.

Last Week

U.S. industrial production was better than expected in April as manufacturers of machinery and automobiles posted solid increases in production. U.S. housing starts in April were also better than expected, rising nearly 7%. The April consumer price index (CPI) rose 0.4%, slightly higher than expected and the largest increase since February 2013. While this price index is not the Fed’s preferred measure of inflation, it could be a worrisome sign and something the Fed might consider when it meets in June to discuss whether or not to raise interest rates.

It was confirmed that Warren Buffet of Berkshire Hathaway purchased $1 billion of Apple common stock and also increased his stake in shares of IBM during the first quarter.

For the week, the Dow Jones Industrial Average shed 0.2% to close at 17,500 while the S&P 500 Index edged higher by 0.3% to close at 2,052. The Nasdaq Composite Index jumped 1.1% to close at 4,769.

This Week

It will be a relatively quiet week for both economic data releases and earnings reports ahead of the Memorial Day weekend. New home sales for April should be higher than the previous month and consistent with a steadily improving housing sector. April durable goods are forecast to be only modestly higher and less than the number in March while the preliminary reading for first quarter GDP is expected to be 0.8%, up from 0.5%.

Retailers will again headline the quarterly earnings reports as Best Buy, Tiffany & Co., Williams-Sonoma, Costco Wholesale, GameStop, Dollar Tree and Dollar General are all scheduled to report. Toll Brothers, Autozone and HP are other prominent companies due to release earnings.

Portfolio Strategy

While the FOMC minutes and remarks from three Federal Reserve presidents last week indicate that an interest rate hike is in play at the June meeting, the yield curve would seem to indicate otherwise. The yield curve or yield differential between the 2-year Treasury Note and 10-year Treasury Note is the flattest the curve has been since 2007. A flat yield curve typically signals the onset of a recession, although this indicator is not always reliable. Benign global inflation and tepid growth have caused investors to take more risk by extending maturities in government bonds and other fixed income securities. Inflation has been running below targets set by global central banks and central banks in Europe and Japan have even resorted to negative interest rates to combat deflation. The Fed really wants to raise interest rates and normalize monetary policy but cannot in the face of weak global growth and muted inflation. As of the close of business on Friday, the difference between the yield on the 2-year Treasury and the 10-year Treasury was 96 basis points. In December 2007, the yield differential was 95 basis points and the Great Recession began the next year. The FOMC minutes from the April meeting may have braced investors for the possibility of a rate hike, but the Federal Reserve also must be careful not to raise interest rates prematurely and send the economy into a recession by doing so.