Before The Bell - The second-quarter earnings season is off and running, with mostly positive results and guidance from the big banks garnering a mixed reaction from the investment community. Our sense is that the solid quarterly figures are likely being offset by concerns that the recent narrowing of the spread between short- and long-term Treasury bond yields will hurt the near-term earning power of the banks. The news from Corporate America, though, is not the primary driving force behind equities right now. Instead, Wall Street still remains fixated on the Federal Reserve, its stance on employment and prices, and whether the recent spike in inflation (more below) will push the central bank to act sooner than originally expected to tighten the monetary reins.
So far, calming comments from Fed Chairman Jerome Powell, even in the face of rising prices and concerns about inflation, have been enough to keep the bull market in place, with the S&P 500 Index establishing yet another intraday all-time high yesterday. In testimony before Congress on Wednesday, Chairman Powell reiterated his stance that the recent price increases will eventually prove transitory once ongoing coronavirus-related supply-chain issues are resolved. The central bank leader, however, did leave the door open that the Fed would not hesitate to raise rates if prices continue to rise at a substantial clip, but all indications are that the long-term pricing picture has not changed much from what it was before the coronavirus pandemic. Mr. Powell’s testimony continues today, and most Wall Street pundits expect him to continue to defend his dovish stance.
This morning, the markets received the latest initial weekly unemployment claims from the Labor Department, and it was yet another sign, along with a record high reading from the Empire State Manufacturing Index, that the U.S. economy is recovering from the damage done last year by the coronavirus pandemic and the resultant shutdowns. Specifically, initial weekly unemployment insurance filings fell to 360,000, a pandemic-era low. That said, Fed Chairman Powell stated yesterday that labor market recovery still has a ways to go, and the current unemployment rate of 5.9% understates the continued stress in the job market. Later this morning, we will get the industrial production figures for June, and tomorrow morning will bring news on retail sales.
The comments from Chairman Powell that the U.S. economy is still far from reaching the Fed’s threshold of “substantial further progress” toward recovering, combined with the central bank’s continued stance that the recent inflationary pressures will prove transitory in nature, is walking back thoughts on Wall Street following last month’s FOMC meeting that the central bank leaders are becoming more hawkish with regard to monetary policy. Now the prevailing sentiment is that the lead bank will not reduce the current pace of asset (Treasury securities) purchases at its next monetary policy meeting. The 10-year Treasury bond yield sitting below 1.35% seems to reflect both Chairman Powell’s current view that the inflation concerns will prove temporary and that the economy still is not fully recovered from the pandemic. The lower bond yields, though, are giving a boost to the high-growth stocks, particularly those of the technology giants, like Apple (AAPL), Alphabet (GOOG), and Microsoft (MSFT).
But even with Chairman Powell continuing to downplay the inflation concerns, we would not, at least in the near term, shy away from the inflation-trade stocks. The latest Producer and Consumer Price Index data showed that prices are continuing to rise at a pretty substantial clip. Recent quarterly reports from food processors General Mills (GIS) and Conagra Brands (CAG) showed that each company is concerned about the impact of rising prices for ingredients, transportation, energy, and logistics on its business. (Those with a subscription to The Value Line Investment Survey can view our latest analysis of the Food Processing industry this week on valueline.com.) In this environment of rising prices, we would look at the stocks of the companies that have the best ability to pass the higher operating costs to consumers via pricing hikes. The food processing and energy sectors may fit this description, as the products provided by the companies in those industries are considered more necessities for everyday living than luxury items that can easily be deferred. This should keep demand healthy, even if the price increases prove more than temporary.
Conversely, the recent spike in prices (the CPI rose at the fastest pace since 2008 last month, while the PPI jumped 7.3% year to year, the fastest rise on record) is hurting the small-cap stocks, as investors fear that the near-term higher operating costs will hurt the smaller companies that don’t have the leverage to push increases onto the customer via higher prices. The small-cap Russell 2000 fell 1.6% yesterday, which was far worse than most of the major indexes. Investors clearly appear to be favoring the stocks of the larger-cap companies that have pricing power as well as the strongest cash positions. This also is working to the advantage of the big-tech companies.
So what is an investor to do right now? With the massive fiscal and monetary stimulus policies of the last year and a half flooding the financial system with liquidity, we would continue to keep a significant weighting of equities in one’s portfolio. The age-old adage “don’t fight the Fed” clearly remains on display, with the major equity averages at or near record highs. But with the resultant extended valuations, we would recommend continue looking at the stocks ranked 1 (Highest) or 2 (Above Average) for Safety by Value Line, as these issues have historically fared better than the broader market when volatility picks up, a scenario that can’t be ruled out with the market looking priced for perfection these days. – William G. Ferguson