Major stock averages mixed ahead of FOMC meeting

Buy not on optimism, but on arithmetic. – Benjamin Graham

After closing at a 52-week high of 2,119 on Wednesday, the S&P 500 fell about 1% during the last two trading days to end the week virtually flat. It looked like momentum would be enough to propel the benchmark index through the all-time closing high of 2,130 but investors had other ideas and decided it was time to take profits. In a week that was void of any potential market-moving economic data or earnings releases, investors had to settle for comments made by Federal Reserve Janet Yellen in a speech in Philadelphia. With the Federal Open Market Committee (FOMC) scheduled to meet next week to discuss a possible interest rate hike, the timing of her speech could not have been better for investors. While Yellen stressed that the Fed needs to raise rates, she offered no time frame as to when that may happen. She also emphasized that the overall labor market is “quite strong”, despite the apparent weakness of the May employment report. Admitting that there is still much uncertainty with regard to the outlook for the economy, she also acknowledged concern about Brexit by warning that Britain leaving the European  Union could have “significant economic repercussions”. On balance, her comments were perceived as mostly dovish, suggesting that the Fed will not raise interest rates at its meeting. There was also profit-taking in the energy sector as oil closed at $49.07 a barrel after climbing to over $51 a barrel earlier in the week. European markets were weak, too, as investors grew wary over the looming Brexit vote and the uncertainty that a yes vote would create. As a result, bond markets around the world rose as investors sought refuge in the safety of government securities. As bond prices rise, yields on bonds fall and the yield on the 10-year Treasury fell to 1.64%, nearly a four-year low. This yield looks downright attractive, though, compared to yields in Europe and Japan, which are even lower. With the Federal Reserve likely on hold at this meeting and earnings growth likely to be lackluster near-term, the stock market appears to be range-bound for the foreseeable future.

Last Week

With a dearth of economic news, there was little for investors to hang their hats on last week. First quarter productivity contracted at an annualized rate of 0.6%, down from 1% reported last month, while unit labor costs increased at a 4.5% pace.

One of the concerns about the decline in the 10-year Treasury yield last week is the flattening of the yield curve or the spread or difference between the yield on the 2-year Treasury and the 10-year Treasury. This difference is now at a nine-year low and could foreshadow economic weakness and slower global growth.

For the week, the Dow Jones Industrial Average rose 0.3% to close at 17,865 while the S&P 500 Index shed 0.15% to close at 2,096. The Nasdaq Composite Index dropped 1% to close at 4,894.

This Week

Retail sales for May are expected to increase modestly but should be significantly less than the 1.3% gain in April. The May producer price index (PPI) and consumer price index (CPI) are forecast to rise more than in previous months but overall inflation should remain subdued. May industrial production is expected to decline slightly after posting a healthy increase last month and May housing starts should be at a level consistent with an improving housing sector.

This will be another quiet week for quarterly earnings reports as Bob Evans Farms, Oracle, Jabil Circuit and Kroger are among the few companies scheduled to report.

Portfolio Strategy

Even though most economists are predicting that gross domestic product (GDP) growth will accelerate in the second quarter, the fact that the 10-year Treasury yield fell to 1.64% raised concerns that the U.S. economy may instead be slowing. Estimates for global growth were recently reduced by the International Monetary Fund (IMF) as developed economies in Europe and Japan also remain sluggish and China’s growth rate has slowed. One consequence of anemic growth is strong demand for U.S. bonds and compared to yields on foreign government bonds, Treasury yields are very attractive. For example, the yield on the 10-year German Bund is only 0.2% and trillions of dollars of sovereign debt are trading with negative yields.  With yields on overseas debt so low, it is no wonder that investors have piled into U.S. Treasury securities, sending their prices higher and their yields lower. Another reason for the low yields has been the European Central Bank (ECB) policy of buying corporate bonds as a way of suppressing interest rates in the hope of revitalizing its economy. With the Brexit vote to determine whether or not Britain stays in the European Union less than two weeks away, investors are taking a risk off approach by reducing risky assets in favor of safe and secure U.S. government bonds. In this low interest rate environment, investors would be wise to diversify across multiple asset classes, including high dividend paying stocks and stocks with a history of raising their dividend year after year. High quality, investment grade corporate bonds also offer investors a significant yield advantage over Treasuries without the risk of high yield or junk bonds, which typically perform the same way as equities. With the stock market trading near its all-time high and yields very low, the most prudent portfolio strategy for fixed income investments is to stick with high quality bonds with short to intermediate-term maturities.