True to form for this year, the stock market offered another roller coaster ride in May with heightened volatility and large daily swings. After losing nearly 9% in April and then a subsequent 5.47% from May 1 through May 19, flirting with bear market territory, the S&P 500 enjoyed a huge rebound in the last full week of May, gaining 6.6%. It was the index’s best weekly return since November 2020. The rebound enabled a slightly positive monthly return of 0.18%, bringing the return for the first five months of the year to -12.76%. Mid and small cap stocks did even better in May, returning 0.75% and 1.86%, respectively. Meanwhile, international indexes also printed positive returns—the developed market index gained 0.89% and the emerging market index gained 0.47%. Energy stocks led the way again; the sector gained more than 15% in May which puts the year-to-date return at 58%. Utilities, financials, health care and materials were all positive for the month as well.

The main bond index, the Bloomberg Aggregate, saw its first positive month of 2022 with a 0.64% gain due to a decline in interest rates. The yield on the U.S. 10-year treasury started the month at 2.94% and closed May at 2.84%; shorter term yields fell even more, with the 2-year treasury yield falling from 2.73% to 2.54% during the month.

If you follow the markets, you were probably encouraged by the late month rally, but you may be wondering if it signals the end of a painful stretch or simply a brief respite before more declines continue. Let’s dive into what happened and what we’re looking at going forward.

One likely contributor to the rebound was that markets may have just been oversold. “Oversold” is commonly tossed around without much unpacking of the term. In this context it means an overreaction. Some like to claim that the market is an efficient pricing mechanism, perfectly valuing every single security based on all information available at that time. This ignores human psychology, specifically the effect of euphoria and greed in good times, and conversely fear and loss aversion in bad times. With the Dow Jones Industrial Average seeing eight straight weeks of decline, a stretch not experienced since 1923, one could reasonably argue that markets were due for a bit of a bounce.

The reversal didn’t happen in vacuum—there were some catalysts which also contributed to the rebound. As we’ve written all year, the narrative weighing on the market has been inflation and the Fed’s plans to tighten monetary policy to combat it. Expectations for how severe that tightening will be have softened over the past month. According to the CME FedWatch Tool the probability of a Fed Funds Rate at 2.75% or higher by the end of this year was nearly 75%; by the end of May that came down to 59%, and furthermore, the probabilities of the rate being north of 3% by year-end fell somewhat as well. This moderation stemmed from a comparatively less hawkish tone from some Fed officials and was reinforced by a decline in inflation from the Fed’s preferred inflation metric, the Personal Consumption Expenditures (PCE) index. The April print of the PCE, released on May 27, came out at a 4.9% year-over-year increase, down from a 5.2% increase from the previous month. In the event inflation does begin to cool, it would afford the Fed some flexibility in the pace and scale of hiking rates. One hopes that April’s reading signals that inflation is receding, but investors should allow for the possibility it is a blip on an otherwise upward or sideways trend.

Markets were also encouraged by comments from JP Morgan CEO, Jamie Dimon. Dimon said May 23 that the U.S. economy remains strong but and the current threats are “storm clouds” that “may dissipate.” This optimism from one of America’s most well reputed CEOs provided a boon to the financials sector in general and contributed to the market rally more generally. It’s worth pointing out that while his May 23 comments boosted stocks, Dimon came back out on June 1 to sharpen his tone, stating that the storm clouds are actually a hurricane and that we just don’t know whether it will be a minor one.

Dimon’s about face is emblematic of the uncertain state of the market outlook. Inflation and the Fed will still be the centerpiece of this year’s market narrative, but as the Fed’s policy begin to create real economic consequences, the focus will be less on what the Fed plans to do and more on the impact of that policy as higher rates cause the cost of borrowing for houses, cars and credit cards to increase. We’re already starting to see the impact of inflation on the consumer. The personal savings rate was impressively high throughout most of the pandemic period due to stimulus checks and less consumer spending. The personal savings rate is now at its lowest level since 2004. Consumers are spending more at the gas pump, housing, and virtually everything else. People can translate this to credit card debt for a time but eventually they’ll have to tighten their belts and reduce other parts of their discretionary budget. Stocks are ultimately driven by earnings, and earnings are hurt when consumers consume less (not to mention they are hurt when costs like labor and materials increase). The strong U.S. consumer has been a shining feature of the economy and markets for much of the past decade, but its resiliency will be tested the longer this high inflation, high borrowing cost environment persists.

One additional threat that has not gotten much press yet is the impact of the Fed’s balance sheet reduction. We have known since March that their bond purchases would stop but that change in policy is only now being implemented as we enter June. The Fed has been an immense provider of demand and liquidity to the bond market over the past decade and this change in policy, which is an entirely different tool than hiking the federal funds rate, may introduce more volatility into the bond market and could have a wider impact.

Markets often react worse to uncertainty than to tangible bad news, and we are in a state of heightened uncertainty. Because of this, investors should be prepared for more volatility in the markets, even if the turbulence is interspersed with strong weeks like we saw in late May. In periods like this we stress the importance of focusing on your long term goals and the suitability of your portfolio for those goals, rather the impact of the markets on your portfolio in shorter timeframes.

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