Market Commentary: Huge Stock Market Rally Continues as Headwinds Ease

The economy continues to surprise to the upside, inflation is coming back to earth, and the Federal Reserve is likely done hiking rates. All these positive drivers have combined to allow stocks to soar this year, with the S&P 500 up more than 15% so far.

• The huge stock market rally continued last week.
• Among several bullish signs: new 52-week highs and eight months without new lows.
• Buying late in the week is yet another clue the bulls are in charge.
• The Fed paused rate hikes for the first time this cycle but signaled more may lie ahead.
• The Fed acknowledged the economy’s resilience and indicated inflation can fall without a recession.
• Inflation appears to be declining.

It might surprise many, but the bear market ended more than eight months ago. At that time, the S&P 500 was down more than 25% into mid-October and events were spiraling out of control. But, as they say, it is darkest before the dawn, and sure enough stocks have soared since those dark days last October. The good news is when stocks go more than eight months without making a new 52-week low, the odds of reverting to new lows are extremely slim. In fact, one year later the S&P 500 has been higher 80% of the time by a median of more than 15%.

The S&P 500 finally made a new 52-week high last week after going 17 months without one. While it’s still about 8% from new all-time highs, a new 52-week high strongly indicates this bull market has lasting power. In fact, we found that when stocks went more than a year without a new 52-week high and finally made one, future returns were quite strong — up 15 out of 15 times and by 17.4% on average.

Stocks have also shown strength late in the week this year. Last year saw heavy selling on Fridays, as investors did not want to hold over the weekend. But this year, Fridays are having a great year. Not to be outdone, Thursdays have seen extreme buying as well. This pattern is another clue that the bulls are in charge.

Why the Fed Wasn’t as Hawkish as Everyone Thinks

The Fed didn’t raise interest rates in June, leaving the federal funds rate in the 5-5.25% range. This was the first meeting in which the Fed held back from rate hikes since March 2022.

However, the big news was that Fed members projected rates to be 0.5% higher than previously expected. Members now predict rates to hit 5.6% at the end of 2023, up from their March estimate of 5.1%. This was viewed as a very hawkish signal, despite the pause in rate hikes.

The last set of projections were made shortly after the Silicon Valley Bank crisis. At the time, Fed members said that potential credit tightening would be equivalent to rate hikes and left projections unchanged.

Fast forward three months: The economy has weathered the banking crisis, even as core inflation (excluding food and energy) remains elevated, and the Fed believes rates should end the year higher.

By contrast, additional materials released by the Fed, including Chair Jerome Powell’s comments, suggest more rate hikes are not a certainty.

The Fed is (Finally) Acknowledging the Economy’s Resilience

Along with interest rate projections, Fed members also updated their economic projections. This is where things got interesting. The updated projections included:

• Raising 2023 real GDP growth from 0.4% to 1%
• Dropping the 2023 unemployment rate from 4.5% to 4.1%

Despite projecting more rate hikes, Fed members seem to believe that economic growth will be stronger than they expected in March and the unemployment rate lower.

They also expect inflation, as measured by the core personal consumption expenditures index (their preferred measure), to be 3.9% by the end of 2023. In March, the expectation was 3.6%. The higher projection makes sense within the context of the current economic strength.

Moreover, Fed members expect core inflation to slow to 2.6% in 2024, leading them to project interest rate cuts worth about 1%, even as the economy grows 1.1% in 2024.

These projections should be taken with several grains of salt. They are not forecasts. They’re more like best guesses.

However, they are signs that Fed officials finally believe inflation can slow without a recession. That’s a significant turnaround from what they’ve signaled over the last year, i.e., a huge economic slowdown or recession is necessary for inflation to fall.

In fact, Powell acknowledged the conditions are in place for inflation to slow — economic growth has fallen below trend while activity remains strong, the labor market is less tight, and supply chain disruptions are easing.

Pausing in June allows the Fed to gather more information about the impact of rate hikes and the banking crisis. However, the July Fed meeting is only six weeks away and there will not be enough data released before then to provide that information. The Fed will be looking for at least three months of data to see how things evolve.

That buys time and indicates that two more rate hikes of 0.25% are not certainties. At the same time, raising the 2023 estimate ensures that investors believe the Fed is serious about curbing inflation while also providing optionality to increase rates if inflation persists.

Good News: Inflation Appears to be Declining

Headline CPI inflation has decelerated from a peak of 9.1% year-over-year in June 2022 to 4% in May. Over the past three months, inflation has run at a 2.2% annualized pace, the slowest three-month pace in two and half years.

The big driver of the pullback has been energy, but more recently food prices have also started falling. Vehicle prices, which boosted inflation last year, are also moving lower. Used car prices rose over the last two months, but private data indicates that will reverse soon.

What’s left? As the chart below indicates, shelter inflation (dark green bar) is the main reason core inflation remains elevated, running at a 5% annualized pace over the last three months. That’s simply too high for the Fed.

The good news is shelter inflation may be at an inflection point. While private data have shown rents decelerating for more than a year now, the official data, which has a significant lag, is just beginning to turn around. It is a bit like turning an aircraft carrier, but core inflation should soon begin to decelerate on the back of falling shelter inflation.

Fed members have said they need to see services inflation excluding shelter decelerate. We received good news on that front. The Atlanta Federal Reserve calculates something called the Sticky Price CPI, which excludes food, energy, and shelter. It measures inflation for items whose prices typically don’t change frequently. Over the past three months, this measure has run at a 2.5% annualized pace, well below last year’s peak of 7.3%.

In addition, the producer price index, which measures input prices for businesses and typically leads inflation, has collapsed to just 1.2% year-over-year in May. That’s well off the peak pace of 11.6% from March 2022 and is lower than the pre-pandemic average of 2%. Even excluding food and energy, PPI is down to 2.8% from 9.7% 14 months ago.

All in all, there’s encouraging news on the inflation front even as the economy remains resilient. Powell’s comments reflect that. That is why we’re not convinced that two more rate hikes are baked in. But we do expect the Fed to leave rates higher for longer.

This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

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