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The economy is rebounding. Need proof? Check out the first quarter earnings reports released by U.S. companies, which show the S&P 500 companies are on track to achieve their highest rate of earnings growth in more than a decade.
Gains aren’t the only reason to be optimistic. More than 55% of Americans received at least one dose of a Covid-19 vaccine in late April. The number of people filing initial unemployment claims hit a new pandemic low of 553,000 in the third week of April, a fraction of 3.5 million a year ago. Consumers are feeling more optimistic, with confidence surpassing pre-lockout levels, according to the weekly Ipsos-Forbes Advisor US Consumer Confidence Tracker.
Unsurprisingly, stock prices also jumped higher. Major US benchmarks hit new all-time highs over the past month. And the S&P 500, which has historically posted average annual gains of around 10%, is up more than 12% in just four months.
All of this good news is fueling rumors of a potential bubble in the stock market. Federal Reserve Chairman Jerome Powell even dared to say that parts of the markets “are a little foamy” after the last central bank meeting, although he declined to say which parts.
Historically, May is one of three months when the S&P 500 declines on average, although it barely does. As the earnings season draws to a close, news from Washington of potential tax or infrastructure legislation could move the market, along with inflation and interest rates.
A season of profits for the history books
The National Bureau of Economic Research has yet to end the recession that began in 2020, but earnings season tells us the worst of the economic recession is over. The first two weeks of May will see the latest wave of earnings reports, including from many retailers.
Among S&P 500 companies that have already released their first quarter results, 86% said their earnings per share were better than analysts expected. This is the biggest positive surprise since FactSet started collecting data in 2008.
The question before May is whether this trend can continue for the rest of the sectors that have yet to report, according to Ryan Kelley, chief investment officer and portfolio manager of Hennessy Funds. Financial and tech companies that have already disclosed their results have driven the historic performance levels we’ve seen so far in earnings season, and Kelley will await confirmation from other parts of the economy.
“We still have a lot to learn from the results season,” Kelley said, adding that the results so far have led to some readjustments in expectations for the year as a whole. “A very significant number of analysts and companies are raising their forecasts for 2021.”
Inflation remains a wild card
Looking at the economic data for the coming month, investors remain focused on inflation and after months of worry the first signs of a real rise in inflation have arrived. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure Index (PCE), rose 2.3% in March from a year earlier, the largest increase since 2018.
“Everyone has focused on the extent to which inflation is going to kick in,” notes Greg Bassuk, CEO of AXS Investments. Tracking this price data will be very important, not least because it could influence the earnings outlook for companies. In turn, the prospect of higher inflation squeezing corporate profits could hamper the extent to which stocks can continue to recover, he adds.
The stock market could calm down if the pandemic suddenly worsens or inflation continues to rise, prompting the Fed to raise interest rates too soon, Kelley adds.
For now, this is not an immediate concern, although Kelley says investors will try to anticipate any move by the Fed before it happens. Traders currently expect a low probability of a rate hike at central bank meetings for the rest of the year. “We still think this market has more to do because there will be a fair amount of time, even a few years, before the Fed hikes rates significantly,” Kelly said.
An increase in volatility
President Joe Biden caused quite a stir in the stock market last month when details of his Made in America plan were released. The proposals include increasing the corporate tax rate from 21% to 28% and restoring the personal income tax rate for high incomes to 39.6%, from the current 37% due to tax cuts. of former President Donald Trump.
Wall Street will closely monitor the development of any tax hikes due to the potential impact on stock prices, Bassuk said. “We’ll want to see how aggressive this proposal will be and whether or not it gets through Congress,” he said.
Beyond earnings reports, economic data and the Fed, the Biden administration’s policy actions could cause some volatility in the stock market in May and beyond, Bassuk said. “Looking ahead over several months, we just don’t see enough certainty in any of these areas. “
In addition, bond market dynamics continue to cause some angst in stocks. The benchmark 10-year Treasury index yield remains close to its high since the start of the year after big jumps in February and March. After decades of broadly falling interest rates and more than 30 years of rising bond prices, investors are trying to figure out what the changing era means.
“When will we see any signs of a rate hike, that seems to be the biggest concern in the market,” Kelley said.
Another interesting development? The volatility has spread to other markets, such as cryptocurrencies, in addition to the traditional assets of stocks and bonds, notes Bassuk. Market volatility in general is the subject of “every other conversation with customers,” he adds. “There’s this tug-of-war between stocks and bonds, and we think that’s going to be a big theme in May.”
The great rotation continues
Finally, four months into the start of 2021, a dominant theme has emerged – and it shows no sign of abating: the so-called ‘big rotation’. Investors continue to favor value stocks over growth stocks, migrating from “high tech stocks and home stocks” to more defensive or cyclical types, Bassuk says.
And Kelley expects that trend to continue as investors look back on sectors and stocks that “got completely overlooked” at the start of the stock market rally last year. “It’s a little thing that’s a big part of what’s going on in the market right now,” he says.