S&P 500 edges slightly higher despite Fed interest rate hike

Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. – Warren Buffett

Each of the three major stock averages posted different results last week as economic data was decidedly mixed and inconclusive and earnings reports were almost nonexistent. The Dow Jones Industrial Average was the best performing index with a gain of 0.5% while the technology-heavy Nasdaq Composite Index continued its slide with a loss of nearly 1%. The S&P 500 Index ended the week where it began and closed virtually flat. The most important news item in the past week came from the Federal Open Market Committee (FOMC) meeting, which decided to raise the federal funds rate by a quarter of a percentage point to a range of 1% and 1.25%. This rate hike had been widely anticipated even though the Fed acknowledged that inflation has fallen short of its 2% target. The Fed’s preferred inflation measure, the personal consumption expenditures (PCE) index, actually slipped to a 1.7% annual rate in April and other measures of inflation have also been weak. But Janet Yellen and the Federal Reserve are convinced that inflation will be higher down the road and believe that GDP growth will be 2.2% for the year, no small task after only 1.2% growth in the first quarter. In fact, the Fed is so upbeat about the economy that it is also planning to reduce the $4.5 trillion in securities on its balance sheet later this year. While the Fed is confident that economic growth will accelerate and allow it to raise interest rates one more time this year, the bond market seems to be marching to the beat of a different drummer. The yield on the 10-year Treasury fell to 2.16% and the yield curve – the difference between yields on the 3-month Treasury bill and the 10-year Treasury bond – has begun to flatten, an ominous sign that could portend a recession. This bears watching as recent economic data has been somewhat weak and inflation has been falling instead of rising, a condition that makes the Fed’s job that much more difficult.

Last Week

Lack of inflation was seen in both the producer price index (PPI), which was flat in May and in line with estimates, and the consumer price index (CPI), which fell 0.1% and was less than expected. Over the past 12 months through May, the CPI has risen only 1.9%. Retail sales dropped in May and recorded the biggest decline since January 2016. Housing starts declined in May for the third straight month and were at the lowest level in eight months. Building permits also fell in May. The National Federation of Independent Business (NFIB) small business optimism index was unchanged in May but small businesses are still hopeful that the pro-growth policies of the Trump administration will be passed. But the University of Michigan consumer sentiment index registered its lowest reading since November as consumers were more worried that distractions in Washington would delay or prevent passage of these policies.

Amazon.com announced that it plans to purchase Whole Foods Market for $13.7 billion or $42 a share, sending both stocks higher on the news as other big retail and grocery chain stocks fell.

For the week, the Dow Jones Industrial Average rose 0.5% to close at 21,384, a new record high, and the S&P 500 Index edged up 0.1% to close at 2,433. The Nasdaq Composite Index dropped 0.9% to close at 6,151.

This Week

It will be a quiet week for economic data as May new and existing home sales are expected to be consistent with the number reported in April and indicative of a steadily improving housing sector. May leading economic indicators should exceed those in April and point to continued modest growth in the economy.

Brexit talks are scheduled to begin this week and a number of Federal Reserve presidents will give speeches on the economy and monetary policy.

The most notable companies scheduled to report quarterly earnings this week include Adobe Systems, Accenture, FedEx, Lennar, CarMax, Barnes & Noble, Carnival and Bed Bath & Beyond.

Portfolio Strategy

The Federal Reserve could just as easily have left interest rates unchanged last week based on recent economic and inflation data. The Fed obliged odds makers who predicted a rate hike but the action did not seem to reflect the reality of the current economy. As mentioned earlier, the Fed’s preferred inflation gauge is running below its target rate of 2% and both wholesale and consumer prices were flat in May. The Energy Information Administration (EIA) also reported a smaller than expected drop in U.S. crude oil inventories and the price of oil skidded below $45 a barrel. May retail sales registered the largest decline in 16 months, a worrisome sign that consumers are tightening their purse strings. Consumer spending accounts for about two-thirds of the U.S. economy and GDP growth is already sluggish. The Atlanta Federal Reserve recently lowered its forecast for second quarter GDP growth, making the average of the first two quarters of the year a modest 2% if its forecast is accurate. In addition to the rate hike, the Fed also addressed the $4.5 trillion in securities on its balance sheet and said it would begin a program to reduce these holdings. Under normal circumstances, these actions would cause bond prices to fall and yields to rise, but the 10-year Treasury actually fell on the news. Part of the reason that yields are so low is that yields overseas in Europe and Japan are even lower, but global central banks will probably be reducing stimulus measures in response to improved global economic expansion. Ordinarily, a tight labor market in the U.S. with a 4.3% unemployment rate would suggest conditions are in place for higher inflation, but so far that has not been the case as wage growth remains modest. While the Federal Reserve desperately wants to normalize monetary policy, it must do so only if the economy is strong enough to warrant increasing interest rates. Otherwise, the Fed runs the risk of sending the U.S. economy into a recession.