Stocks fell last week after the Federal Reserve (Fed) shifted its forward guidance on interest rates in a hawkish direction. Fed officials signaled they expect to raise interest rates by late 2023, sooner than they anticipated in March.
Their projection shows them lifting their benchmark rate to 0.6% from near zero by the end of 2023. In March, they had expected to hold it steady near zero through 2023.
This shift largely reflects a fading of the pandemic-related risks that likely kept most Fed officials cautious through the March meeting. Since then, strong economic growth and rapidly rising rates of vaccination have reduced recovery concerns, while recent high inflation readings—even if bottleneck-related—has refocused attention to medium-run inflation risks.
This shift brings the Fed into closer alignment with markets, which have been pricing 2023 hikes for some time. It also does not change our positive outlook for stocks that we see benefitting from further strong economic growth. The incoming economic data and profit outlook continue to support our positive outlook. While the reflation trade experienced a sharp pullback on the Fed news, we view this as an opportunity to add to cyclical stocks that are benefitting from the strong reopening.
Leading Indicators Point to Continued Fast Growth
The Conference Board’s Leading Economic Index (LEI) rose 1.3% in May, its 13th consecutive gain, and in line with the consensus. Seven of its 10 components made positive contributions, led by fewer initial jobless claims and stronger ISM new orders. On a six-month basis, the LEI increased 4.9%, and the strength was widespread among individual indicators, consistent with above-trend economic growth.
While retail sales came in below expectations, consumer spending is still on track to increase at a 10% rate in the second quarter. In addition, the Atlanta Fed GDPNow model is estimating second-quarter growth will come in at an incredible 10.3%.
CEO Optimism Keeps Rising
Given the strong economic growth we are seeing, it’s not surprising that the Business Roundtable CEO Economic Outlook Index increased in the second quarter to its highest level since the first quarter of 2018, and the second-best reading on record. It was its fourth consecutive increase, reflecting growing optimism about the U.S. economy. Hiring plans for the next six months reached a record high level. Expected sales and capital expenditure plans also picked up. CEOs revised up their projection for economic growth for this year to 5.0% from 3.7% previously.
Inflation Still Seen as Transitory
The Producer Price Index (PPI) for final demand increased 0.8% (6.6% y/y) in May, the fourth biggest gain since data started in December 2009, and above the consensus estimate. A part of this inflation reflects a strong base effect from the lockdown last year, but also reflects meaningful price increases due to strong demand and commodity shortages. We expect these inflation pressures to recede as supply chain disruptions are remedied. Lumber and other commodity prices are now falling as supply/demand issues are worked out which should help ease inflation pressures.
Financial Conditions Remain Favorable
Despite the more hawkish tone from the Fed, financial conditions remain favorable for economic growth. Corporate borrowing rates remain very low and banks are easing lending standards. Consumers are also flush with cash with excess savings estimated at over $2 trillion. Coupled with pent-up demand, this should support economic growth well into 2022.
Profit Outlook Continues to Move Higher
Back in January the consensus forecast for the S&P 500 earnings-per-share was $167 for a growth rate of 22% compared to 2020. As a result of stronger-than-expected economic growth, the consensus estimate has steadily moved up and now stands at $191 for a growth rate of 34%. Cyclical sectors are seeing the strongest growth and upward revisions. Industrials (73%), Materials (65%), Consumer Discretionary (61%), and Financials (48%) are all expected to see very strong profit growth this year that supports a favorable outlook for these sectors as we move into the back half of the year.
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