The S&P 500 looks to close the week at yet another record high. Stocks were certainly helped by the positive comments made by the Federal Reserve regarding the economy. The Fed continued to cut bond purchases by another $10 billion, indicating they see the economy improving. Additionally, nearly all of the economic data this week met or beat expectations. These reports included capacity utilization, CPI, and home builders’ index.
Inflation looks to reemerge, which from the Fed’s perspective, is good news. The U.S. needs to have high nominal GDP growth (real GDP plus inflation) in order to grow out of the budget deficit and reduce the nation’s overall debt levels. With inflation of 2% and real growth of 2-3%, the U.S. could grow nominal GDP at 4-5% annually and slowly bring the deficit under control.
Inflation increased at a nearly 5% annualized rate in May. The core number the Fed prefers, which strips out energy and food, was up an annualized 3.6%. One month’s number doesn’t make a trend, but as we mentioned in yesterday’s ETF Watchlist, data from MIT’s Billion Price Project suggests these numbers will stay at this level for several months. For this reason, some investors are worried about the ramifications of increased inflation.
Over the past 10 days, energy and utilities have significantly outperformed the broader market. The Energy Select Sector SPDR (XLE) is up more than 3%, while Utilities SPDR (XLU) is up more than 2%. During the same period, SPDR S&P 500 (SPY) is up less than 1%. It had looked as though utilities would lose ground as the best performing sector in 2014. However, utilities broke out to a new high on the same day as the Fed’s announcement and energy has also steadily moved upward. It appears that investors are starting to price in higher inflation.
One reason why we have recommended energy and utilities this year is because they typically begin to outperform in the middle of a bull market cycle. During the initial phase of a recovery, slack demand first needs to increase. Only by the middle of a recovery do we start to see inflation pick up as commodity producers fall behind demand. Due to the weak recovery (2% annualized GDP growth almost every year since 2008) and huge increase in U.S. energy production, has kept prices low. We may only now be reaching the middle of an economic expansion cycle when demand pushes up energy prices. If so, the bull market still has several years to run.
One important indicator for utilities will be interest rates: utilities moved higher as interest rates (the 10-year Treasury rate) stayed low on the week. Utilities performed poorly when rates increased in 2013; if inflation remains elevated and economic growth stays strong, higher rates are very likely.