The S&P rose 2.0% and the Nasdaq closed 2.7% higher. All S&P 500 sectors posted gains. Consumer discretionary stocks led the advance, closing 4.8%higher following upbeat results from retailers covering a range of consumer segments. Discount retailers Dollar Tree and Dollar General reported stronger-than-expected revenues and raised their projections. On the higher end of the spending spectrum, department store Macy’s raised its profit guidance and Williams-Sonoma beat earnings expectations. These better results helped bolster sentiment, which was dented last week by downbeat outlook statements from Walmart and Target.
Risk appetite was also supported as investors absorbed the minutes from May’s FOMC meeting. The Federal Reserve confirmed that further 50-basis-point rate hikes at upcoming meetings were appropriate but also that “many participants” judged that front-loading rate hikes “would leave the Committee well positioned later this year to assess the effects of policy firming.”
The positive momentum extended into Europe, with the Euro Stoxx 50 up 0.8%, and Wall Street futures pointing toward a positive start to trading on Friday.
What do we expect?
The big question for markets remains whether the Fed can successfully bring inflation down to target while keeping the rate of economic growth above zero.
The path to achieving this is narrow, but the latest developments support our view that the Fed can achieve these goals.
First, the positive outlook from retailers underpins our view that consumption will remain on a positive trend. Recent retail sales data does not point to an economy on the brink of recession. While the budgets of some lower-income households are being squeezed, overall household balance sheets are robust. Within personal income, wages and salaries were up 7.2% year-over-year in March.
Second, there are indications that inflation is peaking. Goods prices have started to fall, and there are early signs of cooling in the labor and housing markets.
We think this combination of underlying strength in the economy and falling inflationary impulses creates the possibility for GDP growth to slow but remain positive, and for inflation to moderate, even if it remains above target into 2023.
Third, the Fed minutes support our view that moderating inflation and growth will enable the Fed to ease back on the pace of monetary tightening in the latter half of the year. Markets also appear to have faith in the Fed’s credibility. The 10-year US breakeven inflation rate has continued to fall this week, and now implies an inflation rate averaging 2.6% in the decade ahead, down from 3% earlier this month.
How do we invest?
Our base case is that inflation will fall but remain above central bank targets, economic growth will slow but stay above zero, and markets will end the year higher than they are trading today. But in an uncertain world, our investment positions aim to deliver the best chance of outperformance across varying potential outcomes.
First, we recommend that investors prepare for volatility, using options to improve payoff structures and considering drawdown management strategies.
Second, invest in value, which historically has outperformed in environments where inflation has been above 3%. We think value will outperform growth, and we like select value stocks with a quality tilt, global energy stocks, and the UK market.
Third, build up portfolio hedges. We have advocated investing in quality income, dividend-paying stocks, and healthcare for some time, all of which will likely outperform in the case of a recession and help insulate portfolios from volatility. We had also recommended the US dollar, but now think the greenback has priced in much of the Fed rate hike cycle.
Fourth, invest in an era of security. As the war in Ukraine continues, governments and businesses are adapting to this era of security, in terms of energy, cyber and national defense, and food supplies. In the near term, the focus on food and energy security is leading to tightness in various commodity markets—a move we think will support higher raw material prices in the months ahead.
Fifth, diversify with alternatives. Not many investments can help improve the quality of a portfolio regardless of the scenario that materializes, but we believe a diversified allocation to alternatives may be one of them.
Main contributors – Mark Haefele, Christopher Swann, Vincent Heaney, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Read original report – Equities rally as growth concerns recede, 27 May 2022.
