Monthly Economic Insights

Markets reach new highs, but inflation persists

Global markets continued their strong advance in May, extending an impressive rally that has pushed many major indexes to new highs. 

The S&P 500 posted another gain of more than 5%, fueled by strong corporate earnings, continued enthusiasm surrounding artificial intelligence, and resilient economic growth.

Technology companies remain at the center of the story. Strong earnings growth and ongoing investment in AI infrastructure continue to support investor optimism. 

In terms of year-to-date performance, though, the market's strength has also broadened beyond large-cap technology stocks. Emerging markets, commodities, and U.S. small-cap stocks have all delivered strong performance this year, a reminder that diversification remains important even when a handful of companies dominate the headlines.

At the same time, investors continue to navigate a more complicated economic backdrop.

Inflation, as measured by the Consumer Price Index (CPI), rose to 4.2% in May, its highest level since April 2023, and recent data suggest price pressures have proven more persistent than many expected. 

While gasoline prices have remained elevated, they have notably fallen from the year’s high prices. Nonetheless, energy markets remain sensitive to geopolitical tensions, global supply concerns, and ongoing conflicts in several regions.

As a result, expectations for near-term interest rate cuts have largely faded. The Federal Reserve has maintained a cautious stance, and some market participants have even begun discussing the possibility that rates could remain elevated for longer than previously anticipated. Long-term Treasury yields have moved higher as investors weigh inflation risks, economic growth prospects, and growing concerns surrounding federal debt levels.

Despite those headwinds, corporate earnings remain remarkably strong.

Analysts currently expect earnings growth well in excess of 20% over the next year,  far above the long-term average of approximately 7%. Historically, earnings growth has been the primary driver of long-term stock market returns, and today's market remains supported by healthy corporate profitability.

The challenge is valuation. More specifically, how much to pay for this aforementioned profitability.

Investors are currently paying a premium. Market valuations remain well above historical averages, suggesting future returns may depend more heavily on continued earnings growth than on further expansion of stock prices relative to earnings. In other words, businesses may need to continue delivering exceptional results to justify today's market levels.

Bottom Line

The economy continues to demonstrate strength, and markets are responding accordingly. Strong earnings, resilient consumer activity, and, in particular, ongoing investment in productivity-enhancing technologies continue to support optimism. 

However, inflation remains elevated, interest rates are likely to stay higher for longer, and federal debt levels continue to raise important long-term questions. These factors do not necessarily signal immediate trouble ahead, but they do reinforce the importance of maintaining realistic expectations and diversified portfolios.

Finally, yes, we may be entering one of the largest IPO cycles in financial history, driven almost entirely by AI and AI-adjacent businesses. And while these may be transformational businesses, they may not be transformational investments when purchased at excessive valuations. 

Innovation is exciting, but the risks are real, and diversification remains essential.

Invest well. Be well.

— Rusty Vanneman, CFA^®, CMT^®, Chief Investment Officer (CIO), FNBO Wealth

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