Fed rate hike fears send stocks lower

Investing is laying out money today to receive more money tomorrow. – Warren Buffett

The Dow Jones Industrial Average fell for the third consecutive week despite the fact that the preponderance of economic data was positive. A rational person would think that the good news released last week would be reflected in stock prices but that was not the case. Instead, stocks tumbled on renewed fears that stronger than expected economic data will lead to an earlier interest rate hike by the Federal Reserve and higher rates in the future. Part of this fear was realized as the 10-year Treasury yield jumped to 2.40% after the government announced that 285,000 jobs had been created in May, much more than the 220,000 jobs that were expected. The increase in the 10-year Treasury yield was the biggest increase since June 2013 and the infamous Fed taper tantrum. While the unemployment rate increased slightly to 5.5% as more people entered the labor force in search of work, wage growth was also slightly higher than expected, stoking fears of higher inflation. Other economic data released last week, such as construction spending, manufacturing activity, automobile sales and jobless claims, confirmed an economy that seems to be gaining momentum. While the U.S. economy appears to be strengthening, the same cannot be said for global economies, which continue to be weak. This realization prompted International Monetary Fund (IMF) Chief Christine Lagarde to say that the Federal Reserve should delay a rate hike until 2016 and take into account global financial and economic conditions. Her comments might have been directed at Greece and its future in the European Union as the uncertainty over the eventual outcome continues to weigh on  economies in Europe. This never-ending soap opera still has no end in sight as repayment of a loan with the International Monetary Fund was delayed once again on Friday. While most observers still believe that an agreement will be reached to satisfy creditors, it’s possible that Greece could be forced into bankruptcy and out of the euro zone.

Last Week

Leading the parade of positive economic data last week was April construction spending, which rose to the highest level since November 2008. The Institute for Supply Management (ISM) manufacturing index in May also increased. Both reports amplified previous favorable data on business spending, employment and housing and point to an economy that is gaining momentum in the second quarter. The U.S. trade deficit also shrank in April, another sign that economic growth could be higher in the current quarter. The Fed’s Beige Book, which is a collection of anecdotes collected by the twelve Fed regional banks, confirmed these positive trends by stating that economic activity was expanding at a moderate pace and employment levels were up in most districts.

Lending support for Christine Lagarde and the IMF, the Organization for Economic Cooperation & Development (OECD) reduced its estimate for global growth to only 1.9% in 2015 and 2.5% in 2016. They pointed out that business investment was weak due to a modest recovery and doubts over prospects for stronger growth.

For the week, the Dow Jones Industrial Average dropped 0.9% to close at 17,849 while the S&P 500 Index fell 0.7% to close at 2,092. The Nasdaq Composite Index finished along the flat line at 5,068.

This Week

Unlike last week, which provided investors with a wealth of economic data, this week promises to be relatively quiet. The most anticipated economic report will be retail sales for May, which are expected to rise a solid 1.1% due to strong automobile sales, possibly the best in ten years. The producer price index (PPI) for May is expected to increase but still be at levels consistent with low inflation. The small business optimism index for May will be reported as well as the preliminary Michigan consumer sentiment index for June.

The earnings calendar is very light this week with only a handful of familiar companies scheduled to report. Among these are H&R Block, Pep Boys, Casey’s General Stores and Men’s Wearhouse.

Portfolio Strategy

Both the stock and bond markets have begun the month of June on an inauspicious note as rising interest rates have resulted in increased volatility and losses in each market. While we are only one week into the new month, it looks like volatility is here to stay. Improving economic data along with the strong employment report for May that included higher than expected wage gains have given investors confidence that the economy is back on track. Rising European bond yields, especially in Germany, and uncertainty about a resolution for Greece also have weighed on sentiment. It now seems much more likely that the Federal Reserve will raise interest rates at its September meeting, especially if the economic data remains favorable. Part of the anticipated rate hike, though, is probably already priced into the bond market based on last week’s surprising 30 basis point increase in the 10-year Treasury yield. Still, the steep move higher in the Treasury yield is huge considering that yields are at historically low levels. Most economists believe that any rate hikes will be small and gradual, but this could change if the economy heats up, the job market strengthens and wage growth returns. Such a scenario could rattle the bond market by sending yields higher and bond prices and stock valuations lower. Ultimately, though, higher wages should produce higher household incomes, more spending and increased demand in the economy and stronger revenue and profit growth for corporations. For investors that own stocks, this outcome should translate into higher stock prices and provide a situation where good news truly is good news.