Economy is "Good Enough" for Stocks

S&P 500 Notches a New Record

U.S. equities advanced last week, with the S&P 500 Index notching new record closes on Thursday and Friday. For the week, the S&P advanced 0.33% to 2,123, the Dow Jones Industrial Average rose 0.44% to 18,272, and the Nasdaq Composite Index gained 0.90% to 5,048. Meanwhile, bond markets settled after yields spiked earlier in the week with the yield on the 10-year Treasury ending unchanged at 2.15%.

A pullback in bond yields, more mergers-and-acquisitions (M&A) activity and a wave of companies buying back shares all aided stocks last week. Overall, we continue to see an environment of “good enough” growth, reinforcing our view for both bond yields and stock prices to grind higher. That, in turn, leads us to continue to favor stocks over bonds.

Bond Yields Stabilize …

Last week, stocks benefited from companies putting their cash to work. We saw another round of M&A activity with Verizon agreeing to buy 1990’s icon AOL for $4.4 billion, while Danaher is set to purchase Pall for $13.8 billion. In addition, companies continue to buy back their own stock. Last month brought a monthly record with the announcement of $141 billion in share buybacks, up 121% from April 2014.

But stocks also profited from a pullback in long-term bond yields. Earlier in the week, yields on 10-year and 30-year U.S. Treasuries rose to 2.35% and 3.10%, respectively, both highs for the year. However, a combination of factors helped bonds stabilize by week’s end.

First, the Treasury’s auction of 10-year notes met with strong demand, suggesting bond prices have fallen to a level investors find attractive. Second, economic data continue to come in mixed. On the positive side, the labor market appears to be recovering from March’s softness. The four-week average of initial jobless claims hit the lowest level since 2000. However, consumers are still not spending. Retail sales were flat in April, once again coming in below expectations. On a year-over-year basis, adjusted retail sales are now up less than 1%, the slowest rate of growth since 2009.

… As Do Oil Prices

In addition, in what’s becoming a bit of a pattern, last week brought little evidence of inflation, despite rising expectations for a spike. Producer prices in April unexpectedly fell by 0.4%. We believe inflation will remain low for a variety of reasons: a modest recovery, constrained wages and the fact that the recent rally in oil may not have much further to go.

Oil prices have climbed on rising demand, slowing U.S. production and, more recently, falling supply. U.S. crude inventories have now dropped for two consecutive weeks after rising for 17 straight weeks.

However, the recent rebound in oil prices may actually be the impetus for the rally to stall. With U.S. crude prices now 25% above their March lows, U.S. exploration and production companies are considering a resumption in drilling. Two recent examples: EOG said earlier in May that it plans to increase drilling as soon as crude stabilizes at around $65 per barrel while Pioneer is looking to deploy more rigs as early as July.

Any new supply would help to slow the rally and keep oil prices contained, probably in a range between $50 and $70 per barrel. This should help inflation remain both low and stable.

The main consequence of the combination of mixed economic data and still quiescent inflation is that the Federal Reserve is unlikely to raise interest rates before the autumn. This helps explain the rebound in bond prices by week's end, as the 10-year Treasury yield pulled back to 2.15% by Friday. Two-year yields, the most sensitive to Fed policy, slipped to 0.55%, roughly 10 basis points (0.10%) below where they started the year.

Reiterating Some Key Themes

This environment of good, but not great, growth, range-bound oil prices and low inflation supports our basic views on investment positioning. We suggest investors stick with a few key themes: a preference for stocks over bonds, a healthy allocation to international equities and an opportunistic stance in fixed income. We don’t expect bond yields to rise sharply, but as the last few weeks have demonstrated, even a modest backup in yields will inflict some pain.

© BlackRock