Record Highs on the Back of Earnings and AI. Will Inflation Prove Sticky and Derail the Rally?

• The S&P 500 posted its best two-month gain since May 2020, rising over 16% since late March, while the 30-year Treasury yield hit 5.2% in mid-May, its highest since 2007
• New Fed Chair Kevin Warsh faces elevated inflation driven partly by Middle East conflicts affecting energy prices, with markets pricing in a 41% probability of a December rate hike despite administration pressure for cuts
• Economic data divergence shows US surprise index at +40 while Europe's fell to -80, and SpaceX is set to debut at a $1.8 trillion valuation in June amid historically poor mega-IPO performance (median -31% one-year returns)

Market Summary: Record Highs Amid Inflation Concerns

Key Performance Metrics

All three major U.S. indices closed May at record highs despite rising inflation concerns. The Nasdaq Composite surged 8.4%, the S&P 500 gained 5.3%, and the Dow Jones Industrial Average rose 2.9%. The S&P 500 posted its best two-month performance since May 2020, climbing over 16% since end-March. Strong earnings and AI-related momentum drove the rally.

International developed equities and U.S. mid-caps advanced 4.5% and 2.5%, respectively. Bonds showed modest gains, while commodities struggled—crude oil plunged 12.2%, gold fell 1.5%, though silver rose 2.5%.

Inflation and Fed Policy

Kevin Warsh was sworn in as Federal Reserve Chair on May 22, inheriting a challenging environment. May CPI reached 3.8% (highest since May 2023), while PPI hit 6.0% (highest since late 2022). Middle East conflicts drove energy prices higher, contributing to inflationary pressures.

The 30-year Treasury yield peaked at approximately 5.2% in mid-May (highest since 2007), with the 10-year climbing above 4.6%. Fed Governor Lisa Cook indicated preparedness to raise rates if inflation persists. Markets price in a 41% probability of a December rate hike.

Market Implications

Morgan Stanley Research indicates equities historically tolerate higher yields when accompanied by growth, with S&P 500 returning roughly 4.1% quarterly in such environments. Nearly two-thirds of S&P 500 companies are growing revenue by at least 5%.

Economic data diverged between regions—the U.S. Citi Economic Surprise Index rose to +40 while Europe's fell to -80, reflecting Europe's greater exposure to Middle East energy disruptions.

SpaceX's anticipated June IPO at $1.8 trillion valuation draws attention, given historically poor performance of mega-IPOs (median one-year decline of 31%).