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Stocks decline on Fed rate hike fears as inflation remains elevated

It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk. – Seth Klarman 

After finally snapping its longest losing streak since 1923 the previous week with huge gains, the Dow Jones Industrial Average relinquished some of those gains last week by posting a modest loss. Both the S&P 500 Index and the Nasdaq Composite Index also lost about 1% each as a stronger than expected employment report in May meant that the Federal Reserve would likely continue to raise interest rates to combat stubbornly high inflation. May nonfarm payrolls increased by 390,000, above estimates of 325,000, and the unemployment rate remained unchanged at 3.6%. Average hourly earnings rose slightly and were less than expected, but still were up 5.2% from a year ago. While the increase in wages benefits workers, real wages have fallen as consumer prices have risen over 8% and are at the highest level in forty years. Federal Reserve Vice Chairman Lael Brainard commented last week that it’s unlikely that the central bank will pause its current rate hiking cycle anytime soon in its effort to reduce the price pressures. In addition to the interest rate hikes, the Fed has also begun a process called quantitative tightening, which will eventually allow up to $95 billion a month in bond proceeds to roll off its balance sheet, adding to investor uncertainty about the potential impact on the economy. The Fed’s Beige Book, which surveys the 12 Federal Reserve districts across the country, showed that most districts are experiencing only “slight or modest” growth along with price increases that are rising at a “strong or robust” pace. Contributing to the high inflation has been the price of oil, which rose last week after the European Union agreed to ban most crude imports from Russia and China reopened after its Covid lockdowns. Despite assurances from OPEC that oil output would increase, oil prices are likely to remain high and, as a result, bond yields also rose last week as the 10-year Treasury yield hit 2.96% on Friday after closing at 2.75% just a week earlier.

Last Week

Other jobs data released last week was mixed as ADP reported that private sector jobs increased by just 128,000 in May, well short of the 300,000 estimates, while weekly jobless claims fell 11,000 to 200,000, below expectations. The ISM manufacturing index for May was higher than in April but the ISM services index was slightly less than in the previous month. Both readings, though, were still solidly in expansion territory. Consumer confidence in May fell from the level in April as concerns over inflation and rising interest rates were offset partially by an upbeat outlook on the labor market. The JOLTS report showed that job openings fell by 455,000 in April but still substantially outnumber available workers, which is indicative of a very tight labor market. The shortage of workers has pushed wages sharply higher and added to inflationary pressures.

For the week, the Dow Jones Industrial Average fell 0.9% to close at 32,899 while the S&P 500 Index lost 1.2% to close at 4,108. The Nasdaq Composite Index dropped 1.0% to close at 12,012.

This Week

The consumer price index (CPI) for May is expected to increase 8.2% year over year, slightly less than in April, but still way too high and a long way from the Federal Reserve’s stated inflation target of 2%.

The European Central Bank (ECB) meets this week and is expected to keep its benchmark deposit rate unchanged at negative 0.5%. The rate is expected to be positive by September after a couple of anticipated rate hikes.

Among the most notable companies scheduled to report their quarterly earnings this week are Casey’s General Stores, Campbell Soup, J.M. Smucker, Brown-Forman, Vail Resorts and DocuSign.

Portfolio Strategy

After the major stock averages posted gains of more than 6% in the last full week of May, it was disappointing that there was no follow through last week. The week ahead promises to be relatively quiet as the first quarter earnings season is nearing an end and the only important piece of economic data is the consumer price index (CPI) for May. The headline number is expected to be slightly less than in April and lower than the March reading of 8.5%, suggesting that inflation may have peaked and may continue to trend downward. If that is the case, investor sentiment could become more positive even though inflation will likely continue to be elevated. The hope is that by year-end the CPI is about half the current rate, which would still be above the Federal Reserve’s target rate of 2% inflation.  The huge uncertainty about the inflation outlook and the Fed’s plan to hike interest rates has led to increased stock market volatility with the S&P 500 Index briefly dipping into bear market territory on May 20th, falling 20% below its all-time high. This benchmark has since recouped some of these losses and is down about 14% from its record high close. Bear markets tend to be difficult to navigate as they can be characterized by extreme volatility with sharp upside rallies followed by periods of weakness. The stock market could also be influenced by the bond market as higher yields could slow the economy too much and tip the economy into a recession. Higher interest rates also discount the value of future earnings, which can make technology and other growth stocks look less attractive. For this reason, investors should favor value stocks that offer above average dividend yields or a history of consistent dividend growth and trade at below market price earnings ratios.