Market Perspective for May 22, 2015

Stocks reverted to form this week, with small- and mid-caps leading the market higher while the tech heavy Nasdaq outperformed the S&P 500 and Dow Jones Industrial Average. The Nasdaq traded at a new all-time high on Friday and the Dow hit a new all-time high earlier in the week.

A few days ago, the Federal Reserve released the minutes of the prior meeting and it seemed to eliminate the likelihood of a June rate hike. Officials remain concerned about economic growth and the tone of the meeting indicated rate hikes will occur when the economy is on better footing.

The week ended with some contrary data though. Core inflation increased 0.3 percent in April, a 3.6 percent annualized rate, and above the Fed’s target range and double the current annual core inflation rate of 1.8 percent. Rising medical costs helped drive the number higher. One reason why we’ve favored the healthcare sector in recent years is the government’s policy changes, such as the Affordable Care Act, were designed in such a way as to generate cost increases. With increased spending on healthcare, raising premiums and extending coverage to more people, the government’s policies increased demand without raising supply. As we know from economics 101, when demand rises and supply is the same, prices increase.

This could impact Federal Reserve policy because healthcare is a large sector in the U.S. economy and the inflation rate in medical services is picking up speed: the increase in medical costs in April was the largest since 2007 and second largest since the mid-1990s. On Thursday, The Wall Street Journal reported insurers in several states are looking to raise insurance premiums by 30 to 50 percent next year. The reason for the requested premium hikes are due to more people gaining coverage, with the end result being higher healthcare spending in 2016, and a good reason to remain overweight healthcare moving forward.

Another large sector of the economy seeing rising prices is housing. Rent climbed 3.5 percent year on year. Similar to healthcare, prices in this sector tend to be sticky and do not often drop. If a trend to higher prices develops, it is very hard to reverse, which is why the Fed focuses on the core inflation number. Headline inflation, which includes food and energy, fell 0.2 percent because of low oil prices. Headline inflation can continue to fall into the end of the year or at least remain low if oil prices stay around $60 a barrel as it was only in December 2015 that oil first fell below $60. This gives the Federal Reserve time to delay rate hikes, but if core inflation remains elevated, the inflation hawks at the Fed will start making more noise.  A pickup in the economy will also argue for a rate increase. This past week, housing data was positive, with housing starts and building permits in April well above forecasts. The flash PMI for May was down slightly from April, but still in expansion territory.

Long-term interest rates rose and then fell over the past few days, but remain near the highs reached a week earlier. The Federal Reserve does not control long-term interest rates and while the April core number is elevated, it will take several months of persistently high core inflation to change investor expectations. Since things can easily change in a few months’ time, investors should hold off overly betting on rising interest rates, but they should start planning for it and know which funds and strategies are best for their portfolio. Should core inflation remain high through the summer, a September rate hike could become a strong possibility.

Rate hikes aren’t a fait accompli though. One factor working against inflation is the strong U.S. dollar, which keeps a lid on commodity and import prices. The dollar has pulled back from its highs set earlier this year, but the move thus far looks like a correction and not a reversal of the bull market. Greece is likely to be resolved by June, which will significantly impact the euro. Since the euro is the largest component of the U.S. Dollar Index, 57.6 percent, it is the most important currency in determining the direction of the dollar. The yen is the second largest at 13.6 percent of the index. On Friday, the yen was hovering near its 52-week lows versus the greenback.

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