Over the last several weeks, equity markets have been range-bound under a cloud of reasonably positive economic recovery data. Increasing inflationary pressure and expected fiscal headwinds (higher taxes and regulations out of the US) are providing a limit to upside moves except for special situations like AMC this week, which provided some entertainment for market watchers.
With the US markets closed last Monday for Memorial Day, weekly trading volumes were low, possibly signaling summer is around the corner. The TSX advanced 74 basis points as the energy sector jumped on higher oil prices. For the week, the Energy Sector ETF XLE climbed Friday-to-Friday 8.89%. The S&P500 gained 61 basis points, the NASDAQ 48 basis points, while the S&P400 MidCap index was flat, and the Russell 2000 rose 74 basis points as many of the stocks on investor chat pages attracted retail investors’ attention. European equity markets were mixed, with Germany’s DAX up 1.11%, Italy’s FTSE MIB gaining 1.59%, France CAC 40 0.49%, and the UK’s FTSE 100 index up 0.66%. Inflationary concerns tempered optimism on economic recovery. The fear that the Central Bank policy reaction to higher inflation would be to withdraw stimulus, creating a headwind for equities.
Last Tuesday, the ISM Manufacturing index reported increasing to 61.2, above the 60.9 expected and above April’s 60.7. All categories showed improvement, with new orders rising by 2.7 percentage points to 67.0; the backlog sub-index jumped 2.4 percentage points, and export orders gained .5 percentage points. Only two out of 18 of the manufacturing industries reported declines in May.1 On Wednesday, the Labor Department released the most recent initial claims number totaling 385,000, a decrease of 20,000 from the previous week and the lowest level since March 14, 2020. Continuing claims also fell to 15,435,982, a decline from the previous week of 366,178.2 The unemployment rate fell to 5.8%, the lowest level since March of last year. In May, US employers added 559,000 new jobs compared to economist expectations of 650,000.3 The pickup in job growth is an encouraging sign that the re-opening is gaining strength, especially in areas most impacted by the pandemic. Leisure and hospitality added 440,000 new jobs, health services, and education added 139,000, while transportation and utilities gained 118,000. According to ADP payroll data, private employment increased by 978,000 in May. The services sectors in total added 850,000 to payrolls, and manufacturing gained 128,000. However, payrolls are short 7.6 million people compared to pre-pandemic levels. Employers continue to be challenged by labor shortages as restrictions and fear slow re-employment.4
As the range-bound equity markets bounce from one data release to another, one dominant theme is inflation and the Fed’s reaction. The Fed has determined a dual mandate: to control inflation while maximizing employment. In recent statements, the Fed sees current inflationary pressure as transitory and caused by supply chain shortages resulting from the government-mandated economic shutdown. The Fed’s thinking is as we return to full employment, supply chain shortages will recover, eliminating the need to respond to the “transitory” inflationary pressures, thus holding rates low for a more extended period. One concern with this approach is the Fed’s fear will keep rates low for too long, letting inflation spiral out of control, forcing a more aggressive response, unsetting equity markets. Another possibility is the Fed could slowly reduce bond purchases as they have previously attempted. As in the past, this too was unsettling to equity markets. In pursuit of more robust broader-based employment, increasing interest rates is considered the last resort response to inflation.
The net result is increased equity volatility no matter the Fed policy response. With growing earnings and revenues, we remain constructive on equity markets, although an equity correction will not be unexpected as the economy resumes and equity markets slowly climb higher.
Warren Gerow is an independent investment wealth consultant to Sightline Wealth Management.
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