May’s employment report is the big event in the week ahead, as stocks enter the often weak month of June.

Stocks are finishing May with a mixed performance. Big cap indexes like the S&P 500 and Dow notched slight gains, while the small cap Russell 2000 was flat and the tech-heavy Nasdaq declined.

June is not historically a strong month for stocks. Bespoke Investment Group points out that over the past 50 years, the Dow has gained just 0.12% in June and has been positive 52% of the time.

But over the past 20 years, June was far weaker, gaining only 40% of the time. June’s performance is tied with September as the worst month of the year, with an average Dow decline of 0.7%, according to Bespoke.

The economy is front and center in the coming week with the important ISM readings on manufacturing and services sector activity, but the most important measure will be Friday’s jobs report. According to Dow Jones, economists expect Friday’s employment report to show the creation of about 674,000 jobs in May, after the disappointing 266,000 jobs added in April. That was about a quarter of what economists had expected.

“You know if we have two months in a row of not delivering on the jobs expectations, the market is going to get nervous,” said George Goncalves, head of macro strategy at MUFG. “Hopefully, we beat it and then that creates a positive buzz, and we go into the Fed meeting and then we’re ‘hey, the economy is still on track.'”

The Fed meets June 15-16 and already, market pros are anticipating it will be the most important event of the month. Fed officials have emphasized that they will keep policy easy as they watch to see signs that the economy is really healing. They also contend that higher inflation readings are temporary, since the data is being compared to a weak period last year.

Key for the markets is whether the Fed begins to believe that inflation is higher than it expected or that the economy is strengthening enough to progress without so much monetary support. Fed officials have said they would consider discussing tapering back on their quantitative easing bond purchase program if they see signs of improvement, and that would be a first step toward interest rate hikes, not expected until at least 2023.

If inflation runs too hot, the Fed’s main weapon to combat it is to raise interest rates.

The prospect of higher interest rates makes the stock market nervous, since it would mean higher costs for companies and less liquidity. In theory, higher interest rates also means that investors could potentially choose higher yielding bond investments over stocks.

The next big read for the economy is Friday’s jobs report, and it looms large as recent inflation readings have come in much hotter than expected. The latest was the personal consumption expenditures price index Friday. It showed core inflation running at 3.1% year-over-year, the strongest reading for that measure since 1992.

The Fed’s beige book on the economy is expected Wednesday. ISM manufacturing data is expected Tuesday, and ISM services is released Thursday.

Inflation flare-up

The Fed has said it would tolerate an average range of inflation around its 2% target until it sees inflation sticking at a higher level. Inflation has been running mostly below 2%, prior to the latest numbers.

“With the PCE number coming in like every other inflation number over the last six weeks, hotter than expected, the market is inching closer to calling the Fed out on its view that inflation is transitory,” said Julian Emanuel, head of equity and derivatives strategy at BTIG.

Emanuel said the speculative activity around meme stocks, this past week is a sign of froth and shows a large amount of liquidity in the hands of investors. One of those stocks AMC, was slightly higher Friday, after rallying 120% in the past week, giving it a 2021 gain of 1200%.

“The net net on the index level is basically it’s a stock market that’s moving sideways,” Emanuel said. “Our view continues to be that when you look at it longer term, the big picture is this is a bull market that started in March of last year that has further to run. When you look at it in the medium term, the market has every right to be concerned and we do believe they will amp up their concern that the Fed’s paying insufficient attention to price stability.”

Emanuel said he studied what happened to stocks when core PCE was above the Fed’s 2% target. “The average monthly return for months where the core PCE has been over 2%, going back to 1989 is (a decline) of 1.6%, with a decided bias toward more defensive sectors like health care outperforming and a very pronounced bias for technology of all kinds to underperform,” he said.

Technology stocks, as measured by the S&P information technology sector, gained 1.8% in the past month, and are up 6.3% year-to-date. The sector is lagging the S&P 500’s 12% gain.

The top performing sectors have been cyclical year-to-date, with energy, up 36.6%, financials up 28.6%, materials up 20.2%, and industrials up 18.5%. Communications services, which contains some internet growth names, gained 16.3% since the start of the year. Health care has been outperforming information technology, up 8.6% year to date.

Red flag?

On the edges of the financial markets, market pros are paying attention to signs of a huge surge of liquidity in the financial system. In the past week, institutions have been placing unprecedented amounts of cash with the Fed, nearly a half trillion dollars Thursday.

“There’s way too much liquidity in the system, and it’s happening as a result of the Fed’s ongoing QE, but also disbursements from the fiscal stimulus,” said Goncalves.

He said the funds from trillions in stimulus, including to state and local governments have not yet been spent but have found their way into the banking system. At the same time, institutions and individuals continue to move funds into money market funds, now holding about $4.6 trillion.

Those funds also put pressure on the system, since they put funds in Treasury bills. Goncalves expects the Fed to raise rates on excess reserves if the situation gets worse.

“There’s no precedent for this because it is totally a function of there being just too much money in the system,” he said.

“Institutions are redepositing cash at the Fed because they don’t have enough bills or short-term commercial paper. There’s not enough fixed income assets to go around,” said Goncalves. He said banks also do not want to hold the excess cash since it counts against their leverage ratio, and they would prefer to find other higher yielding investments.

What it has done is sparked some speculation that the Fed would taper its QE program sooner than expected, he said.

Week ahead calendar

Monday

Memorial Day holiday

Tuesday

Earnings: Canopy Growth, Hewlett Packard Enterprise, Ambarella, Zoom Video

9:45 a.m. Manufacturing PMI

10:00 a.m. ISM manufacturing

10:00 a.m. Construction spending

Wednesday

Earnings: Advance Auto Parts, Lands’ End, NetApp, Splunk, Cloudera, PVH, C3.ai

Vehicle sales

8:15 a.m. ADP employment

2:00 p.m. Beige book

Thursday

Earnings: Broadcom, Lululemon Athletica, Five Below, Hovnanian, Express, J.M. Smucker, Express, DocuSign, Cooper Cos, CrowdStrike

8:30 a.m. Initial jobless claims

8:30 a.m. Productivity and costs

9:45 a.m. Services PMI

10:00 a.m. ISM Services

Friday

8:30 a.m. Employment

10:00 a.m. Factory orders