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Inflation worries could temper stocks rally

More signs of strong economic growth may boost stocks this week, but concerns about inflation and rising interest rates could put a damper on a summer rally before the season officially starts.
/ Source: Reuters

More signs of strong economic growth may boost stocks this week, but concerns about inflation and rising interest rates could put a damper on a summer rally before the season officially starts.

Reports on industrial production, retail sales and housing starts and regional manufacturing are expected to show a strong U.S. economy. But rising rates have led to concerns about the housing market, and more importantly, how fast the Federal Reserve will move to dampen the quickening pace of inflation.

The Consumer Price Index, which economists expect will show a gain of 0.4 percent when it is released on Tuesday, will be one of the most closely watched economic reports this week. A higher number for the overall May CPI could force Alan Greenspan and the Federal Reserve to lift interest rates faster than originally planned.

Greenspan said last week that Fed policy-makers will do "what is required" to keep inflation in check. A top policy-maker also said the Fed must raise rates faster and farther than currently thought if prices rise too fast.

William Poole, president of the Federal Reserve Bank of St. Louis, told Reuters last week that uncertainty about inflation was substantial, and the Fed must be prepared to act.

In general, economic data this week will show a strong economy, but there are concerns about how higher interest rates will affect the housing industry, said John Caldwell, chief investment strategist at McDonald Financial Group, part of KeyCorp.

"The question that investors should be asking themselves right now is: 'With the Greenspan comments' last week, 'have they set the stage for a less measured pace?'" he asked.

The stock market could either rise or fall in the days ahead as it's not really expensive or blatantly cheap, Caldwell said. Stocks are in a trading range, though the benchmark Standard & Poor's 500 index could rise 6 percent or 7 percent before year's end, he said.

Good news vs. high anxiety
"You've got good economic news, you've got good corporate news," Caldwell said. "Yet there are concerns about the Fed raising rates, there are concerns about how high interest rates move in the market."

U.S. markets were closed on Friday for the funeral of former President Ronald Reagan. But concerns about inflationary pressures weighed on stocks in Europe. The FTSE Eurotop 300 index of pan-European blue chips fell 0.21 percent. In Japan, the benchmark Nikkei average dipped 0.42 percent after chip and flat-screen shares slid on concern about a slowdown in technology markets.

All three major U.S. stock market gauges finished last week higher, keeping alive a rally that began a month ago. Some have called this a summer rally.

"The question is: 'Does it last into the summer?'" said Richard Suttmeier, chief market strategist at Joseph Stevens & Co. "The summer rally is likely to be over before the official start of summer" on June 20.

For the week, the Dow Jones industrial average rose 1.6 percent, the Standard & Poor's 500 Index gained 1.2 percent and the Nasdaq Composite Index added 1 percent. Year to date, the Dow and Nasdaq are still down slightly, while the S&P 500 is just barely in positive territory.

Snapshot: Retail sales, factories and housing
Consensus estimates for major economic data this week include on Monday a 1 percent rise for retail sales in May and on Wednesday a 0.8 percent gain in May industrial production with May plant capacity usage running at 77.5 percent.

Data on housing starts, also due on Wednesday, is expected to show homebuilders broke ground at a seasonally adjusted annual rate of 1.95 million new units, while new building permits are expected to come in at an annual pace of 1.97 million.

Both Caldwell and Suttmeier said that as interest rates rise, it will make bonds more competitive as an investment compared with stocks, because corporate earnings growth will be tougher to maintain in the third and fourth quarters.

Suttmeier said stocks as measured by the S&P 500 index might flirt with the March 5th intraday high of 1,163, but it will be difficult to surpass that level. Higher rates, and less earnings potential, will more likely push stocks lower.

"The higher the 10-year yield goes, the more difficult it is to accept the high price-to-earnings multiples, because you're starting to see the 10-year yield as a better alternative to stocks," Suttmeier said.