Last Friday we saw inflation jump 8.6% (shelter, gasoline and food being biggest contributors). This was an increase from the prior month and the largest increase since December of 1981. Investors are now questioning if 50 basis point increases from the Federal Reserve is enough to rein in inflation. The Feds meeting this week led to a .75% interest rate increase.  As a result, yields have increased on the likelihood that rate hikes may be more aggressive in the coming months. There is also the possibility that the Fed may decide to raise rates in-between regularly scheduled meetings. Higher yields to control inflation will likely slow the economy down as borrowing costs for mortgages, cars, credit cards etc. move higher. This uncertainty in the bond market is flowing into the equity market as stocks fell hard on Friday and look to have another selloff today.  The S&P500 is down greater than 20% year to date so we are officially into bear market territory. The silver lining here is that the selloff in stocks has caused valuations to no longer look stretched.  The S&P500 is trading very close to its 25 year average price-to-earnings ratio of 16.8x (according to JPMorgan).  While a further drop in equities is possible, stretched valuations in stocks is no longer a concern.  Investors should expect a volatile summer in the markets as gas prices continue to creep higher and eat into discretionary consumer spending.  Consumer discretionary stocks have been the worst sector of the stock market this year, losing almost 30%.  Long-term investors should expect to experience this type of volatility as part of a healthy stock market cycle.  With the Fed focused on inflation, the bond market will also continue to be volatile for the months ahead until inflation begins to wane.  It is important on these days to remember that panic is not an investment strategy and we have experienced these types of economic uncertainties in the past.

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Key Points:

• Stocks were slightly positive in May, but volatility continues to remain high.
• Energy stocks continue to be the leading equity sector as energy prices remain elevated
• The US Bond market experienced its first positive month of the year as yields fell

Stocks remained volatile in May as investors continue to question if the Federal Reserve can control high inflation without causing a recession.  Over the coming months, the market will be anxiously watching US and global economic data.  If economic data is too strong it could be inflationary; if it is too weak it could be viewed as recessionary.  This uncertainty has brough volatility to equity markets.  The S&P500 eked out a 0.18% monthly gain while half of its daily returns were greater or less than 1%.   Investors continue to eye high energy prices and their effects on consumer spending.  This has caused some companies to lower expectations for future earnings, specifically in consumer stocks. 

Six of the eleven major equity sectors were positive for the month with energy stocks continuing their market dominance.  The rebound in energy prices in May resulted in energy stocks gaining 15.8% for the month and 58% for the year.  Utilities (+4.3%) and financials (+2.73%) were the next biggest gainers.  Real estate (-5%), consumer discretionary (-4.9%) and consumer staples (-4.61%) were the worst performers of the S&P500.  Small caps were flat for the month after a challenging April while the tech-heavy NASDAQ lost another 1.93%.  The NASDAQ Composite is down 22.5% for the year after strong double-digit gains over the past 3 years.  International stocks gained modestly with the MSCI All Country World ex-US Index up 0.72% in May, but still down 10.72% for the year.  Stocks in Europe and Asia are still being influenced by the Russian invasion in Ukraine as well as shutdowns in China.

Bonds saw their first positive month of 2022 with the Bloomberg US Aggregate Bond Index gaining 0.64%.  Longer duration municipal, Treasury and mortgage bonds performed the best as yields fell.  Fed Chairman Jerome Powell expects 50 basis point increases in the Federal Funds Rate at the June and July Federal Reserve meetings in an effort to slow down inflation. The bond market has largely priced in these moves already.  After July, it is expected that the Fed will take a “wait and see” approach to monetary policy. Higher interest rates usually lead to slower economic growth which has caused credit spreads to start to widen. As a result, high yield bonds lagged the overall bond market in May.

While there are fears of a recession in the US in the coming quarters, a look to the job market paints a different picture.  The unemployment rate stands at 3.6% and there are a record number of job openings. Consumer and business spending continues to be strong in the US but may moderate with higher interest rates.  Should we experience a technical recession (two consecutive quarters of negative GDP growth), it will likely be mild.

Sources: Morningstar Direct, JPMorgan, First Trust, Wall Street Journal