The CPI is a commonly-used proxy for inflation. It measures the change in prices paid by urban consumers for a representative basket of goods and services. On Monday, the CPI measure was reported for May. The report showed CPI rising 2.1% year-over-year, a higher rate than the market had anticipated, and marking the third straight month of solid gains. Much of the gain may be attributed to higher food and energy prices, with food prices up 0.5% and energy up 0.9% from April.
The CPI report tied in closely with another noteworthy event this week – a two-day meeting of the Federal Open Market Committee. The Fed maintains a long-running inflation target of 2%. Measures higher than this indicate that the Fed may choose to tighten monetary policy sooner rather than later in order to keep inflation within their targeted zone. Despite the higher CPI reading, the Fed directive and press conference indicated ongoing patience to remain accommodative.
Historically, higher inflation has a tendency to indicate higher bond yields. Higher bond yields due to inflation have had a tendency to pressure equity prices due to an expectation of slower economic activity. Interestingly, this was not the case last week, or for the past 12 months, ending May 31, 2014, during which equity price advances on days when yields have risen have significantly outpaced price movements when yields have fallen. Total return for the S&P 500 Index on up yield days has been 24.9% versus 16.5% for the full year period. Cyclical sectors, like technology and industrials, have benefited the most.
Why would signs of advancing inflation and higher bond yields correlate with higher stock prices? Most likely, investors are saying that improving employment trends and global economic activity can tolerate a modest uptick in yields and inflation. There is $1.233 trillion – equivalent to 90 weeks of net income – sitting on the balance sheets of S&P 500 companies. With this much cash, companies are in a better position to grow without relying on higher cost debt to slow earnings momentum.
For now, we appear to be in an equilibrium state where equity price momentum and employment trends say that corporate conditions are strong enough to withstand higher rates and modest inflation. Where do we invest in these conditions? CLS believes that Technology and Energy, two of our innovation sectors, appear to be attractive investments.
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Bonds are a type of debt instrument issued by a government or corporate entity for a defined period of time at a fixed interest rate. Bonds may be subject to unsystematic risks including, but are not limited to, call risk and reinvestment risk. High yield bonds, or junk bonds, will be subject to an even greater degree of these risks as well as subject to the credit risk.