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Stocks close higher despite fears over slowing growth, Covid-19 variant

When navigating the financial markets, the long-term investor must keep in mind the four basic dimensions of long-term return – reward, risk, cost and time – and must apply them to every asset class. Never forget that these four dimensions are remarkably interdependent. – John Bogle

The stock market overcame fears that economic growth may have peaked as well as increasing concerns over the spread of the Covid-19 Delta variant to close higher and post modest gains. Despite these worries, all three major stock averages closed at record highs even as volatility returned to unnerve investors. On Thursday, Japan declared a state of emergency in Tokyo due to a surge in coronavirus cases and announced that the Olympics would be held with no spectators. While the variant of the virus is also spreading in the U.S., the fact that nearly 60% of adults have been vaccinated has eased concerns about a setback in the reopening of the economy. Nevertheless, fears that economic growth was slowing also surfaced on Thursday when the yield on the 10-year Treasury dipped below 1.25%, only to recover the next day to end the week at 1.37%. The 10-year Treasury yield had nearly doubled during the first quarter, rising from 0.9% to begin the year to 1.75% on March 31st, only to fall back during the second quarter. Fear of inflation had been replaced by fears that the best of the economic recovery from the pandemic may be behind us and that a correction in the stock market may be on the way. However, minutes from the June Federal Open Market Committee (FOMC) meeting showed that Fed officials did not share the same concerns over economic growth and were in no hurry to begin tapering their monthly bond purchases. While they acknowledged the existence of inflation, they saw the recent spike as transitory and were mostly dovish about their continued easy monetary policies. Investor’s pessimism over slowing growth and Covid-19 fears on Thursday was replaced on Friday with optimism as the 10-year Treasury yield rebounded off its lows (bond yields move inversely to bond prices) and all three major stock averages surged to complete a winning week for the market. The next big test for the stock market occurs on Tuesday when JP Morgan Chase and Goldman Sachs kick off second quarter earnings season.

Last Week

The Institute for Supply Management (ISM) services sector index in June fell to 60 from a record high the previous month and was below expectations. Although it was still a solid month, the drop may suggest that shortages and price increases are becoming a drag on hiring and economic activity. Weekly jobless claims were 373,000, higher than expected and higher than in the previous week as job growth shows signs of slowing.

For the week, the Dow Jones Industrial Average gained 0.2% to close at 34,870 while the S&P 500 Index added 0.4% to close at 4,369. The Nasdaq Composite Index also rose 0.4% to close at 14,701. All three major stock averages ended the week at record highs.

This Week

Both the producer price index (PPI) and the consumer price index (CPI) for June are expected to jump again although not as high as in the previous two months. Economists forecast a 4.0% year-over-year increase in the core CPI, which excludes volatile food and energy prices. Retail sales for June are expected to decline but not as much as in May and the preliminary University of Michigan consumer sentiment index is expected to be slightly higher than in June but still well below the level reached before the pandemic.

The Bank of Japan (BOJ) meets and is widely expected to keep its short-term interest rate unchanged at negative 0.1%.

Financials will dominate the first week of second quarter earnings season as JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, Blackrock, State Street, U.S. Bancorp, Charles Schwab and PNC Financial are scheduled to report. Other notable companies on the agenda include Conagra Brands, Pepsico, UnitedHealth Group, Delta Airlines and Taiwan Semiconductor Manufacturing.

Portfolio Strategy

Second quarter earnings season begins this week and the results are expected to be excellent with profits of S&P 500 companies forecast to increase 65% from the same quarter in 2020 during the height of the pandemic. This quarter could very well signal the peak in corporate earnings growth with the strongest growth coming from sectors such as the industrials, the financials, the materials, energy companies and consumer discretionary companies. The banking industry will lead the earnings parade this week and profits for the group are expected to double from this time last year. All of the major banks also just passed the Federal Reserve’s stress test which enabled them to increase their dividends and buy back their stock. Worries that the drop in the 10-year Treasury yield and the flattening of the yield curve might hurt bank net interest margins has weighed on their stock performance recently, but strong earnings should help alleviate those concerns. Even though corporate earnings growth is forecast to slow for the balance of the year, profit growth is still expected to be in the double digits. With earnings returning to slower, more normal rates of growth, however, volatility likely increase as well. Inflation data in the form of the consumer price index (CPI) and the producer price index (PPI) will also be released this week and could lead to gyrations in the market. The longer that inflation remains at these high levels, the greater is the likelihood of a change in Fed monetary policy, which could result in tapering or higher interest rates. It will also be important to watch the yield on the 10-year Treasury. As the yield fell last week, stocks sold off but then rebounded on Friday when the 10-year Treasury yield rose to close well off its low. Lower bond yields portend that the economy may be slowing.