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Key Points for the Week

  • The Consumer Price Index, a measure of inflation, increased a higher-than-expected 8.6% in May, the fastest pace since December 1981. Core CPI, which excludes food and energy prices, rose 6%.
  • The U.S. trade deficit fell 19.1% in April as imports fell and exports increased.
  • Stocks and bonds declined as markets prepared for further Federal Reserve interest rates hikes to control inflation.

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Economic Update

Inflation is proving to be far more tenacious than markets had hoped.

The idea that inflation peaked in March was put to rest last week when the Consumer Price Index (CPI) showed that inflation accelerated in May. Overall, prices were up 8.6 percent last month, an increase from April’s 8.3 percent. It was the highest inflation reading we’ve seen since December 1981.

The most significant price increases were in energy (+34.6%) and food (+10.1%). That’s unfortunate because the War in Ukraine has added to existing price pressure on food and energy.

With inflation rising, the Federal Reserve is expected to aggressively raise the federal funds rate. There is a 50-50 chance the Fed will raise rates by 0.75 percent in July (rather than 0.50 percent), and some economists say there could be a 0.75% hike this week when the Fed meets, reported Scott Lanman and Kristin Aquino of Bloomberg.

The inflation news unsettled already volatile stock and bond markets. Major U.S. stock indices declined last week as investors reassessed the potential impact of higher interest rates and inflation on company earnings and share prices, reported Randall W. Forsyth of Barron’s. The Treasury yield curve flattened a bit as the yield on two-year Treasuries rose to a multi-year high, reported Jacob Sonenshine and Jack Denton of Barron’s. The benchmark 10-year Treasury Note finished the week yielding more than 3 percent.

There was a hint of good news in the report. The core CPI, which excludes food and energy prices because they are volatile and can distort pricing trends, dropped from 6.5 percent in March to 6.2 percent in April and 6.0 percent in May.

The Federal Reserve’s favored inflation gauge is the Personal Consumption Price (PCE) Index, which will be released on June 30.

This Week in the Markets

The S&P 500 dropped last week as investors digested new inflation data released on Friday. May’s Consumer Price Index (CPI) report showed a reacceleration of inflation after a brief reprieve in April. Headline CPI increased 8.6%, which is the fastest pace since December 1981. The primary drivers of inflation were energy and food prices. Gasoline prices increased 4.1% in May, a big reversal from the 6% decline in April. Food prices, primarily from grocery store spending, climbed 1.4%.

Core CPI, which removes the effects of food and energy, decreased slightly from 6.1% to 6% but remained stubbornly high. The primary driver was vehicle prices with used car prices increasing 1.8% since April.

Markets responded to the higher inflation read by pricing in more aggressive rate hikes, which hurt both stock and bond indices. The S&P 500 declined 5% for the week, once again testing bear-market territory, falling 17.6% so far this year. At the time of publishing early Monday morning, stocks had extended their losses and were poised to decline more than 20% from their highs. Bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, declined 0.9% to bring their year-to-date total to -8.9%.

The U.S. trade deficit fell 19.1% in April. U.S. imports declined sharply, following several months of businesses briskly increasing inventory in the wake of supply-chain disruptions. Meanwhile, exports continued to grow through April, thanks to more food shipments, which jumped sharply, the strong performance of industrial supplies, and capital goods. Still, the trade deficit in April remains large compared to pre-pandemic levels. This continues to reflect the strength of the U.S. economy compared to other major economies, which is a trend economists expect to continue for the foreseeable future.

The big event this week will be the Federal Open Market Committee meeting, in which the Fed is expected to increase the federal funds rate by 0.5% for the second meeting in a row. The market will be paying attention to Chair Jerome Powell’s comments on expectations for the July and September meetings.

Persistently High

Last month, it looked like inflation pressures were stabilizing. Gas prices declined by 6%, food price increases appeared to be slowing, and vehicle prices had fallen for three straight months. The FOMC set the stage for 0.5% rate increases for June and July, but there was some indication the Fed would pause hikes in September if inflation moderated further.

Unfortunately, consumer price increases reaccelerated in May. Headline inflation increased 1%, which brought the yearly number to +8.6%, the highest level since December 1981. Energy prices led the way as WTI crude oil increased from around $105 per barrel to $115. Gas and natural gas prices increased right along with oil. Overall, energy prices only account for 7% of the weight in the basket but accounted for 25% of the gain. Food prices were another big contributor, increasing 1.2% in May. Grocery store prices generated the most pressure, increasing 1.4% versus a 0.7% increase for eating out.

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The stubbornness of core CPI, which removes the impact of energy and food, was most disappointing. Automobile prices were main drivers, especially as used cars climbed 1.8% since April. This was the first time used car prices increased since January and is a sign the sector continues to struggle with supply constraints, particularly in microchips. Vehicle inventories are only 17% of the levels they were prior to the COVID-19 pandemic.

The main reason for the Fed’s “transitory” thesis last year was members expected supply-chain constraints would ease and consumer behavior would normalize after the pandemic ended. This has occurred to a degree, but not nearly as quickly as experts thought. The war in Ukraine and the COVID shutdown in China have extended the supply chain issues.

At the same time, there is some evidence that demand for goods in the U.S. is falling, which caused some prices to fall. The report showed a decline in prices of some goods, such as major appliances (-2% month over month), bedroom furniture (-1.6% month over month), and sporting goods (-0.2% month over month). Also, several major retailers have indicated they have a lot of inventory built up, which will likely lead to price cuts over the summer. But this good news wasn’t nearly enough to offset the large price increases in other parts of the economy.

One of the side-effects of elevated inflation is consumer debt is beginning to rise again. During the pandemic and its after-effects, borrowers had begun to pay off debt as they received government stimulus checks and had fewer ways to go out and spend money. At the same time, personal savings reached levels not seen since World War II. Now, with no further stimulus checks and consumers experiencing higher inflation, revolving credit crossed the record high last seen in February 2020, reaching $1.1 trillion. This spending could be a good sign for the economy as consumers seem comfortable adding to their debt but could also be a concerning trend for personal balance sheets, especially if the jobs market reverses course and becomes tighter.

This week the market will be paying close attention to the Federal Open Market Committee meeting, in which it’s widely expected that Jerome Powell and the rest of the Federal Reserve governors will approve a 0.5% increase to the federal funds rate. While there shouldn’t be a surprise there, special attention will be paid to any hints at a change from the projected 0.5% increase in July and any comments on expectations for September. The market already responded last week to expectations that rates will increase, but additional clarity from the Fed will be helpful to establish a direction for the market moving forward.

It’s also important to acknowledge that talk of a recession has picked up recently. The Fed has a difficult job of trying to bring down inflation by raising interest rates just enough without turning economic growth negative. The good news is the economy still appears strong — consumer demand is high, unemployment is low, and the economy has added more than 1 million jobs in the past three months.

Stubborn inflation has raised a concern that additional interest rate hikes will pressure markets now and the economy in the future. Last week’s performance reflects those concerns. It also reflects concerns the decline in some speculative investments may trigger short-term selling pressures across markets. Last week’s decline and subsequent weakness in pre-market indicators this week suggest the S&P 500 may decline more than 20% from its previous peak. While some short-term traders may be pushed into selling based on short-term concerns, now is a good time to take advantage of your longer horizon. If you are nervous, check with your advisor and see if this short-term volatility has had any effect on your long-term plan.

Bear Markets

  1. he Standard & poor’s 500 Index has experienced 7 bear markets over the last 50 years and recovered from all of them, reported Thomas Franck of CNBC. Here’s a rundown of the duration and returns of bear and bull markets since 1973.
Year Bear market Total return Bull market Total return
1973 21 months -48 percent 74 months +126 percent
1980 20 months. -27 percent 60 months +229 percent
1987 3 months -34 percent 31 months + 65 percent
1990 3 months -20 percent 113 months +417 percent
2000 31 months. -49 percent 60 months +102 percent
2007 7 months -57 percent 131 months +401 percent
2020 1 month -27 percent TBD TBD

“Bull markets tend to last far longer and generate moves of far greater magnitude than bear markets. Time after time, bear markets have proven to be good buying opportunities for long-term investors,” explained Franck. Remember, past performance does not guarantee future results.

  1. Stay diversified. Make sure your portfolio remains well diversified. During bear markets, some segments of the market will outperform while others underperform. A diversified portfolio can provide a cushion. Diversification won’t help you avoid a loss, but it can help minimize it.
  2. Talk with us. During market downturns, investors often panic. That causes some to sell investments and incur losses that may be difficult to recover. If you’re tempted to sell, give us a call first. We’ll discuss your concerns, review your portfolio and help you decide on a course of action.

Possibly the most important things you can do during a bear market are to stay calm and resist making any sudden moves.

Did you Know? This Week in History

June 14, 1777: Congress Adopts the Stars and Stripes

During the American Revolution, the Continental Congress adopted a resolution stating that “the flag of the United States be thirteen alternate stripes red and white” and that “the Union be thirteen stars, white in a blue field, representing a new Constellation.” Based on the “Grand Union” flag, which was a banner carried by the Continental army in 1776, the national flag became known as the “Stars and Stripes,” and consisted of 13 red and white stripes.

There has been debate amongst historians as to who designed the new canton for the Stars and Stripes. According to legend, Philadelphia seamstress Betsy Ross, at the request of General George Washington, created a design consisting of 13 stars and a blue background.

With the entrance of new states into the United States after independence, new stripes and stars were added to represent new additions to the Union. In 1818, however, Congress enacted a law stipulating that the 13 original stripes be restored and that only stars be added to represent new states.

On June 14, 1877, the first Flag Day observance was held on the 100th anniversary of the adoption of the Stars and Stripes, and in 1949, Congress officially designated June 14 as Flag Day, a national day of observance.

Weekly Focus

Falsehood flies, and the truth comes limping after it.

Jonathan Swift, Satirist

Absence is to love as wind is to fire; it extinguishes the small and kindles the great.

Roger de Bussy-Rabutin, Memoirist