May Market Insights

Stocks ended May higher, even after faltering in the second half of the month. U.S. large-cap stocks (S&P 500) gained 4.96% while small caps (S&P 600) rose 5.04%. On the international front, developed-market international stocks (MSCI EAFE) gained 3.87% while emerging-market stocks (MSCI Emerging Markets) rose 0.57%. The Bloomberg U.S. Aggregate Bond Index, a broad measure of bonds, edged up 1.70.*

WHY IT HAPPENED

While stock indexes posted net gains in May, the month was a tale of two markets, with the S&P 500 posting robust gains in the first half but then declining in the second. What drove the market’s turnabout? If nothing else, May’s performance reminds us that one can’t always cleanly attribute one specific driver to the market’s actions.

On the one hand, a mere four stocks fueled much of the gains in the S&P 500: Alphabet, Apple, Microsoft and Nvidia, and much of that gain was Nvidia itself. Why? Investor excitement over artificial intelligence technology.

But the market’s gains also had economic underpinnings. For months, the market has been scouring every economic report for signs of economic cooling and declining inflation, with the hope that either or both will prompt the Federal Reserve to cut rates. But the dynamic has changed as the economy has defied forecasts and remained robust. Instead of wondering when the Fed will decide to lower rates in order to avoid a recession, market participants are now more focused on when the Fed will be confident that inflation is quashed and will feel comfortable lowering rates.

Economic reports in the first half of May buoyed optimism for a cut as they indicated moderating job growth and weakening retail sales and manufacturing activity. But there is still no sign of a recession. Just as importantly, the Consumer Price Index showed a slight decline in the rate of inflation. The market’s expectations for two rate cuts this year rose from 13% on April 30 to 100% by May 15 and stocks rose in tandem.

The expected chance of two interest rate cuts this year fell to 45% in the second half of the month and stocks gave up some of their gains. Why? The market can have a number of drivers at any given time, and one of those drivers in the second half of the month was the Fed itself. Minutes from the Fed’s latest policy meeting signaled that the Fed needed more data to prove inflation was decisively moving toward its 2% target before cutting rates. At month’s end, the Fed’s preferred inflation gauge, the core Personal Consumption Expenditures price index, didn’t do much to change expectations of interest rates, with the index rising by an annualized 2.8%, just about where it’s been all year.

What should we be thinking about

Last month’s market performance underscores three points to remember about the markets and the economy.

First, it’s important not to read too much into any one economic data point even though the market may, driving volatility. While the market cheered news in mid-May of a slight inflation decline, that one data point did not change the longer-term reality that inflation has been more stubborn than was expected a few months ago. Second, some data points are complicated to estimate, and are revised. We saw this with the revision of the first quarter’s GDP growth rate.

That brings us to our third point: Historically, economic growth and higher rates can go hand in hand. If rate cuts are seen as needed to shore up a struggling economy, the ability to hold rates higher for longer can indicate continued economic strength.

Though we may be seeing economic growth moderate, the economy is still chugging along when the data is taken together – job growth remains intact along with GDP growth. The Fed has breathing room to wait until inflation declines further before it cuts rates. When a rate cut will happen is difficult to predict, but we know not to get caught up in the interim noise.

Instead, Edelman Financial Engines designs diversified portfolios to help achieve long-term goals, so clients can worry less about the economic data points in between.

* Index return data provided reflects “total return,” which includes income generated by securities held within the index, such as dividends and interest. Because it includes income, index total returns can differ from index price returns that only consider prices.

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