Federal Reserve Walking a Tightrope

Market Overview

Markets were fairly quiet during May as the economic picture became cloudier. Robust growth prospects for the world’s largest economy were partially offset by a weaker than expected jobs report for the month of April that showed gains of just 266,000 jobs compared to the 1 million expected by market economists. On the back of this release, the swirling debate has been over potential drivers for the slow uptick in employment data. The main causes include broad labor shortages stemming from ongoing government benefits as well as employee concerns surrounding COVID-19. To combat the former, more than 20 Republican-leaning states have announced an early curtailment of support for the unemployed in advance of the September expiration. This prevailing backdrop in the labor market coupled with inflation readings which have also outpaced market expectations have led to the Federal Reserve facing a tricky policy pivot. While Fed officials had adopted a universal adherence to a shared script of speaking points to dismiss inflationary concerns, recent policy meeting minutes indicate that some officials would like to talk about the possibility of scaling back the Fed’s massive monetary stimulus package. With the implications of such action far reaching, this adjustment in rhetoric is laying the groundwork to gradually wean investors and the economy off unprecedented crisis support.

In corporate America, first-quarter earnings reflected a balmy outlook for most constituents within the S&P 500. According to Factset, for Q1 2021 (with 95% of the companies in the S&P 500 reporting actual results), 86% of S&P 500 companies reported a positive earnings surprise, or “beat”. If 86% is the final percentage, it would mark the highest percentage of S&P 500 companies reporting an earnings “beat” since FactSet began tracking this metric in 2008. Given the stock market is a discounting mechanism, historically, “better or worse” would supersede “good or bad” which would suggest that individual shares outperform when expectations are exceeded. Uniquely, data from Deutsche Bank revealed that shares for Q1 reporters which beat expectations underperformed slightly, in contrast to the usual outperformance. This unusual behavior implied that the market was expecting to be surprised (as odd as it sounds). While the tone out of publicly listed corporates was broadly upbeat, the lack of positive reaction ultimately indicates that most of the “good news” was already reflected in market prices.

Asset Performance:

Performance was broadly mixed across domestic indices as equity markets seemed to lose their footing following May’s big miss in employment data. This lackluster labor reading combined with the aforementioned spike in inflation figures tested the Federal Reserve’s outlook for strong growth and “transitory” inflation. While core US equity indices either completely or partially retraced early month losses, the intra-month volatility was visible with broad-based weakness across risk assets. To this extent, the oft-cited NYSE FANG+ index – representing exposure to 10 of the most highly traded tech giants – witnessed a decline of 9.1% over the first half of the month as a noticeable cooling effect took place in this recently hot corner of the market. The soured mood for stocks was also linked to the steep plunge in Bitcoin after China announced new regulations to delegitimize the world’s largest cryptocurrency.

While equity markets experienced periodic bouts of angst, calm largely descended across bond markets as the present tone of relief was not ruffled by the evidence of hotter inflation readings. Over the first three months of 2021, expectations for a punchy restoration of economic activity drove the US 10- year benchmark rate to a peak of 1.77%.

Key U.S. Index ReturnsYTD ’21May ’21
S & P 500+12.6%+0.7%
Down Jones Industrial Average

Rel Fixed Income YieldsYE 2020

May ’21

U.S. 10-Year Treasury Note.92%1.58%
Investment Grade Corp (C0A0)1.8%2.1%
High Yield Corp (H0A0)

Source: Factset as of 6/1/21

Following this rapid shift, a period of consolidation has played out with the 10-year rate idling near 1.6%. When observing market-based expectations for inflation going forward, the bond market appears to be endorsing Fed officials’ view that hotter consumer price pressure could indeed prove short-lived. This inflation “tug-of-war” will likely continue for a few months, which will have major implications for future asset returns.

Closing Thoughts:

Since February 2020, the Fed’s balance sheet has increased $3.6 trillion to a record $7.7 trillion(!). Combined with multiple rounds of fiscal stimulus, we have observed an unprecedented accumulation of liquid assets flooding both the markets and the economy. The effects have truly been distortional. While interest rates are slumbering, we are ever wary that the fortunes of certain, highly valued equities largely rest on the Fed’s exit strategy as “the great unwind” of monetary support unfolds.

Warm regards,
Ash Heatwole, CFA
Portfolio Manager, Associate Director of Wealth Management

Stocks offer long-term growth potential but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. Stock dividends are not guaranteed. Investments primarily concentrated in one sector may be more volatile than those that diversify across many industry sectors and companies. The technology industry can be significantly affected by obsolescence, short product cycles, falling prices and profits, and competition from new market participants. Global/International investing involves risks not typically associated with U.S. investing, including currency fluctuations, political instability, uncertain economic conditions, different accounting standards, and other risks not associated with domestic investments. Investments in emerging markets may be subject to additional volatility. Stocks of small and mid-cap companies may also be subject to greater risk than that of larger companies because they may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. The value of fixed income securities will fluctuate with changes in interest rates, prepayment payment rates, exercise of call provisions, changes in the issuer’s credit ratings, market conditions, and other variables such that they may be worth more or less than original cost if sold prior to maturity. There is also a risk that the issuer will be unable to make principal and/or interest payments. Although treasuries are considered free
from credit risk they are subject to other types or risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate, and deflation risk, which may cause the principal to decline and treasury securities to underperform traditional securities. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is not indicative of future results and there is no assurance that any forecasts/targets mentioned in this report will be attained. The indices have been provided for information/comparison purposes only. Individual investors cannot directly invest in an index.

Ashley Heatwole, Chartered Financial Analyst


Associate Director of Wealth Management, Portfolio Manager