NEW YORK (Reuters) – Investors will focus on the Federal Reserve’s monetary policy meeting next week as the “Goldilocks” market environment that has helped stocks reach record highs and subdued a Bond liquidation is put to the test by rising inflation.
Shares have risen steadily in recent weeks and are now at new highs, continuing a rally that saw the S&P 500 gain 13% this year and nearly 90% from its March 2020 low. US states have also recovered from their first quarter liquidation, with the benchmark 10-year Treasury yield moving inversely to price, recently at 1.46%, around 30 basis points below its highs of the first trimester.
Some of these gains were based on assurances from the Fed that rising inflation won’t last long enough to justify ending the quick-money policies sooner than expected. Signs that the Fed is less and less confident in these assumptions could disrupt stocks, which benefited from quantitative easing, and hurt bonds as higher prices erode the value of longer-term debt.
Investors “will be looking for signs that the Fed may believe inflation is more permanent,” said Michael Arone, chief investment strategist for State Street Global Advisors.
The Fed maintained that it had the tools to deal with accelerating inflation. The central bank could open the discussion at Tuesday-Wednesday’s meeting on when to start unwinding its $ 120 billion-a-month government bond purchases, though most analysts don’t expect it to be. a decision ahead of the Fed’s annual conference in Jackson Hole, Wyoming, in August.
For now, it looks like some investors are buying into the Fed’s thinking on inflation. On Thursday, stocks swept data showing consumer prices rose in May at their fastest annual pace in 13 years, as the S&P 500 hit a new high. In contrast, a much higher than expected inflation figure last month caused stocks to sell off.
High inflation figures aside, recent data has offered snapshots of an economy that is strengthening but does not appear to be close to overheating. Employment, for example, remains around 7.6 million jobs below its February 2020 peak as the latest monthly report failed to respond to economists’ estimates.
“We are making progress, but the economy is not completely on fire and a runaway train where the Fed needs to take action,” said Chris Galipeau, senior market strategist at Putnam Investments. “That puts us in the ‘Goldilocks’ scenario.”
Yet others fear that markets have become too complacent about inflation and other risks that could derail the current recovery, from potential tax hikes to spikes in economic growth.
BofA Global Research analysts on Friday described a number of reasons why inflation could be more sustained than many realize, including second-tier indicators such as the National Federation of Independent Businesses survey of small businesses showing that price pressures are passed on to customers.
“The list of excuses for transitory inflation is growing. The risk of higher and more persistent inflation increases, ”BofA analysts wrote.
More generally, bullish sentiment among individual investors has been above its historic average of 38% in 25 of the past 30 weeks, according to the American Association of Individual Investors. Bearish sentiment, meanwhile, is below its historic average of 30.5% for the 18th week in a row.
“At current levels, pessimism remains exceptionally low,” the AAII said on its website. “Historically, below-average readings for bearish sentiment have been followed by below-average six- and 12-month returns for the S&P 500 Index.”
Bulls can point to many reasons why stocks stay strong. Most investors believe the Fed won’t start cutting its bond purchases until late 2021 or early next year. Bets on the Eurodollar futures markets show investors believe the Fed will start raising its benchmark rate at the end of 2022.
Rising estimates of corporate profit growth are also supporting stocks. Profits on the S&P 500 are now expected to jump 36% this year, from an estimate of 26% in April, with earnings expected to rise around 12% in 2022, according to Refinitiv IBES.
That hasn’t stopped some of the world’s biggest banks, including Morgan Stanley, from warning in recent months that the market is poised for a sharp pullback.
Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, continues to favor stocks over bonds, with a preference for healthcare, industrials, tech and communications services.
“We were due to some volatility and we said it, and yet the declines were met by very strong demand,” he said.
Additional reporting by Karen Brettell; Editing by Cynthia Osterman