June threw some interesting news our way, even as the stock market entered the sleepy months of summer. As a stellar first-quarter earnings season wrapped up, investors zeroed in on recovery, inflation, and monetary policy. These topics got plenty of media attention, but a look beyond the popular headlines can tell you a lot about what's likely to drive the market in the second half of the year.
1. Tea leaves in the "Dot Plot"
The Fed's modest shift in expectations was well documented following the Open Market Committee (FOMC) meeting in June. The central bank previously committed to keeping rates low through 2024, but the Fed moved that timeline up by a year due to new economic data showing a faster-than-expected economic recovery and higher-than-expected inflation. That's pretty big news on its own, but the so-called "Dot Plot" suggests an even more extreme pivot occurring among monetary authorities.
The Dot Plot shows the target interest rates for each member of the FOMC across various time frames. None of the 18 committee members are seeking rate hikes this year, but seven of them are targeting higher interest rates in 2022. Six more members are targeting hikes in 2023. None of these future changes are set in stone, but it illustrates an important story going on beneath the surface.
Inflation might force the Fed to taper a few years ahead of schedule. That change, of course, would probably lead to stock market volatility and maybe even a moderate correction. Make sure your investment strategy and portfolio allocation are set up to ride out that storm.
2. Everyone is bracing for inflation -- are we overreacting?
It seems that everyone is expecting high inflation, whether it's "transitory" or a longer-lasting trend. Wall Street is certainly preparing for rising prices across the economy. The CEOs of multiple banks, including JPMorgan Chase's Jamie Dimon, recently publicly stated that said banks are stockpiling cash in anticipation of inflation.
Consumers share this sentiment. The NY Fed's Survey of Consumer Expectations measures and reports data on peoples' expectations for various economic indicators. May's edition showed a sharp rise in expected inflation rates one year from now, along with increased uncertainty among respondents about that forecast.
This is all warranted -- asset values have risen dramatically, workers are demanding higher wages, commodity prices have been soaring, and consumer price metrics are notching higher-than-average growth rates. Expansionary monetary policy and fiscal stimulus are fueling inflation through a sharp economic recovery, and supply chain issues are exacerbating those effects in the short term.
While inflation is on the minds of consumers and corporate executives, it's getting a ton of media attention. It's certainly not something to be ignored, but we have to accept the possibility that all the hand-wringing might have caused an overreaction.
The Fed maintains that inflation is temporarily high and is bound to subside as supply chains normalize. That stance was partially validated late in June as commodity prices moved sharply downward. This was especially pronounced in lumber and metals, at least in part due to a targeted supply increase from China to pull prices downward.
The verdict here: Continue to monitor inflation, but don't freak out right now. There's still a lot of uncertainty in a global economy that hasn't fully recovered from an ongoing pandemic. The Fed acknowledged rising prices, so they're paying close attention to the issue. We're going to have a period of faster-than-average price growth, but we're far from crisis levels at the moment.
3. All news is good news -- is that terrible for investors?
For the second straight month, stock indexes rose immediately following weaker-than-expected employment reports. May's jobs data marked an improvement above April's, but economists were still expecting even more people to find work in the month.
People have every reason to feel optimistic about economic recovery from the pandemic, but we're still navigating a challenging situation. Lots of people retired earlier than expected. Others relocated and will need to find new roles as offices reopen. Many business owners closed up shop for good, and some will inevitably struggle to find the right fit as they transition from employers to employees. Enhanced unemployment benefits have created less incentive for the unemployed to return. Child care needs have forced many parents home as well.
In short, things aren't going to bounce completely back overnight. Some of the hardest-hit industries are still far from pre-pandemic levels, and people at lower income levels are disproportionately affected.
Despite all of those challenges, major stock indexes are pushing record highs. It's definitely weird that the economy is still inhibited while the stock market climbs. We're in a situation where capital markets are being dominated by interest rate forecasts. If economic news is too good, the Fed is more likely to raise rates ahead of schedule, which would probably send stocks tumbling.
When employment is worse than expected, it means rate hikes move further out into the future. On the other hand, economic strength and impressive corporate earnings get investors excited about the fundamentals of the underlying companies.
I hesitate to throw around the word "bubble," and I don't think it quite applies right now. However, we are looking at stock valuations that are well above historical average levels. We're also in an odd spot where stocks rise specifically when bad economic news is published. Long-term investors can probably ignore these complications that are likely to cause some short-term turmoil at some point. However, investors need to recognize that this is happening and prepare themselves for the consequences along the way.