Week Ahead: More Equity Records After Dovish Fed; USD Weaker, Gold Stronger

US equities finished last week by hitting new records and the dollar retested a two year low after the Federal Reserve signaled on Thursday, that it would begin targeting higher inflation, in direct opposition to its previous monetary policy strategy.

According to remarks by Fed Chair Jerome Powell, the central bank will tolerate inflation running higher than the 2% benchmark it's had in place since the Great Inflation of the 70s and 80s, in essence keeping interest rates at historical lows for longer.

The hope is this will encourage spending and investing. And indeed, existing Fed easing appears to have already insured that this will be the best August for equities in 34 years and the best summer of market returns—June through August—since 1938. We're anticipating more of the same this coming week as the rally after the third bear market in two decades continues.

The tech-heavy NASDAQ posted another fresh record on the final trading day of last week, and the S&P 500 registered a sixth consecutive double record—on both a closing and intraday basis. Even the Dow Jones Industrial Average, which remains 3.1% below its Feb. 12 closing record, has turned positive for the year.

Still, equity investors find themselves holding a candle that's burning at both ends—rebounding economic growth but fueled by unprecedented Fed easing—as the central bank extends its accommodative policy, even as economic momentum appears to have improved. On Friday, the monthly personal spending release showed an increase of 1.9% in July, the third straight month of growth.

Overall the US economy rebounded during the last three months, based on signs suggesting it continues to climb out of worst recession since the Great Depression. Indeed, the Federal Reserve Bank of Atlanta forecast 26% GDP growth for the third quarter.

While this sounds promising, it’s important to frame context for this data. Second quarter GDP plunged 32% annually. Still, if the 26% GDP growth estimate is actualized, the economy will have recovered half of the virus induced contraction, rendering the GDP roughly 5% below its pre-pandemic level. That remains a long way off the metrics seen before COVID-19, but admittedly a heck of a lot better than we expected.

The housing market has also been surprising to the upside, with both new and existing home sales each exceeding pre-coronavirus figures dating back to 2006. Consumers have been driving the recovery in additional ways as well:rerouting spending from travel and leisure to durable and other hard goods, propelling July retail sales roughly 1% higher from figures seen in January, when coronavirus seemed like little more than a local problem in China.

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But of course, this resilience would likely be impossible without unprecedented policy support, via record low interest rates and direct government aid, which so far seems to have worked as intended. Because of the sizable fiscal support, personal incomes in July were almost $1 trillion higher than in February.

Nevertheless, while retail data has been better than anybody would have expected, business conditions remain challenging. Industrial production is still about 8% below its peak, demonstrating weak demand, even after improving for three months in a row. Surveys reveal expectations are for a solid pace of recovery ahead. But only time will tell if that optimism is justified.

Strong retail but weak business circumstances is ironic, and indeed appears mismatched to the labor market. Unemployment remains high and its heralded recovery has been uneven. Nearly half-a year after a record 6.9 million Americans lost their jobs in March, initial jobless claims continue to come in at more than a million per week, higher than at any time during the Great Financial Crisis following the 2008 crash.

The initial rapid improvement in unemployment was facilitated by the return of the temporarily furloughed workers to their previous jobs when the economy reopened after the March closures. More recently, as activity in large segments of the services economy continues to be constrained, some of the temporary layoffs are becoming permanent (the number of permanently unemployed doubled from February to July), which poses a threat to consumer confidence and the trajectory of the recovery.

As the Dow Jones turned positive for the year, it completed a bullish pattern, setting it on a path to 30,000. Similarly, small caps are now in hot pursuit of multi-national mega caps peers. The Russell 2000 just completed the same bullish pattern, setting the stage for smaller, more nimble domestic firms to dominate gains through next year.

Should this scenario play out, it might suggest a relatively better economic recovery for the US than competing economies, conflicting with the reports that Europe is set to overtake the American economy because the continent was better prepared for pandemic, though others see that view as hubris.