"Inflation is like toothpaste. Once it's out, you can hardly get it back in again." - Karl-Otto Puhl

The stock market’s activity in the second quarter was largely a case of “much ado about nothing,” or, at best, very little. The Dow Jones Industrial Average managed to eke out a 0.7% price gain for the period (dividend reinvestment not included). How well stock investors fared during the quarter largely depended on which stocks they owned. And the only ones apparently worth owning were (as the case has been for, lo, these many months now) the gang known by the acronym FAANG (Facebook, Amazon, Apple, Netflix and Google). Hmmm. What is it about this picture that harks back to the heady days of the dot com boom at the turn of the century? Trees still don’t grow to the skies and a handful of tech stocks can’t prop up the entire market forever. Let us hope that breadth widens out in the second half of the year lest the fangs poison the rest of the market a la the dot com debacle.

Bonds likewise mostly held their own but, here again, selection was paramount. Despite a slight uptick in Treasury note yields during the period, the highest quality bonds provided the highest total returns while the corporate and high yield sectors experienced price declines more than offsetting their coupon income returns. While the stock market’s course for the remainder of the year is anyone’s guess, more of the same appears to be on tap for bonds as interest rates are likely to move higher in an environment of rising inflationary expectations and a Fed determined to quash same. We shall have more to say on this anon.

Commodity prices largely rose during the quarter and the CRB Index experienced a 2.6% gain. Most of this was attributable to rising crude oil prices as OPEC has been successful of late at roping in supply levels.

After fizzling somewhat in the first quarter with a disappointing 2% annualized GDP growth rate, the economy appears to have picked up some momentum in the spring quarter. Initial claims for state unemployment insurance benefits remain near historically low levels and the jobs market is very near full employment. Help wanted signs are ubiquitous and the only thing holding employment growth down a tad is the lack of skilled workers to fill the available jobs.

The housing market has remained relatively strong as has business construction spending. Personal consumption is on the rise following the increase in disposable income derived from a strong jobs market. In short, the “virtuous cycle” is in full effect and typically it is self-sustaining. Alas, all of this positive activity has awakened a creature that has been long dormant – the specter of inflation.

For quite a while the Fed has had a target rate of roughly 2% for the broad inflation indicators and for much of the past decade inflation has been conspicuous by its absence. It appears, however, that the tide has now changed from ebb to flow as inflationary expectations are on the rise. The latest year-over-year change in the Producer Price Index is 3.1%. The same measure for the Consumer Price Index is 2.8%. Clearly these levels are above the Fed’s target and it came as no surprise that the central bank made its seventh consecutive tightening in this cycle on June 13 by raising the federal funds target rate to 1.75-2.00%.

There are other measures of inflation that we track and they, too, are telling the same story. The personal consumption expenditures price deflator (say that five times real fast) year-over-year change is now 2.3%. Last year at this time it was 1.4%. The Institute for Supply Management’s report on the percentage of its membership reporting having to pay higher prices for inventory is 78.6% versus 55.0% a year ago.

Hence, inflation has appeared at the door, and it looks like the Fed is prepared to take further action to shoo it away. In the past, unfortunately, this has typically resulted in economic recessions. The hope is that the new “steady as she goes” policies currently in place will succeed in taming inflation expectations without inducing the undesirable by product of sustained weakness in the economy. We certainly wish them well. Meanwhile, let’s ditch the punch bowl and cut back on those durations.

                                                                                                          Weaver C. Barksdale, CFA

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