Inflation data may no longer be the great catalyst for equities that it once was.
US stocks rebounded to close higher on Thursday, even as investors received encouraging inflation news after the consumer price index for December posted its first monthly decline since the pandemic swept the world in 2020.
Considering that inflation has been one of the biggest issues for the markets over the past year, investors might have expected equities to take off.
Instead, after an earlier pullback, stocks ended Thursday with modest gains, the magnitude of which was much smaller than other recent CPI release days.
While the monthly CPI fell by 0.1% in December, the annual indicator fell for the sixth consecutive month to 6.5% from 7.1%. That’s the lowest level in more than a year and down from last summer’s 40-year high of 9.1%.
To get a better idea of what led to such a subdued reaction in stocks, despite the economic milestone, MarketWatch gathered insights from market strategists on what happened.
The “whispered number”
Perhaps the main reason equities greeted the CPI data with disappointment was that investors had positioned themselves for inflation to fall even more aggressively. Some even hoped the drop would be large enough to prompt the Federal Reserve to reconsider further interest rate hikes.
Prior to the CPI data for October and November, economists had actually underestimated the degree to which price pressures had receded, year-over-year. And as prices for commodities like used cars and oil and other commodities fell late last year, traders expected them to be too conservative again in December. .
As a result, a “whispered number” shared among market professionals suggested that underlying inflation – which is the Fed’s main target – would slow even faster than economists expected, according to strategist Bill Sterling. worldwide at GW&K Investment Management.
Instead, the base level, which omits volatile food and energy prices, rose 0.3%, matching the median forecast of economists polled by The Wall Street Journal.
Options traders were too optimistic
According to Charlie McElligott, managing director of multi-asset strategy at Nomura, who compiled options stream data in a note shared with clients and reporters.
Shortly before the data was released, McElligott said stocks could be “set for disappointment” if the data came in “just in line” with expectations.
Traders increasingly used options to trade CPI reports and other closely watched data releases, like MarketWatch reported.
The report did not move the needle
Several market commentators noted following the CPI report that the data did not fundamentally change expectations about when interest rates will peak, or how quickly the Fed will move from rising rate to their reduction.
After the report, interest rate futures traders bet on an increased likelihood that the Fed would slow the pace of its rate hikes to 25 basis points in March. While they had previously considered such a move extremely likely, they now see it as a virtual certainty.
But expectations for when the Fed might start cutting rates were relatively unchanged, with traders continuing to expect the first cut to come in the fall.
Perhaps the main reason for this, according to Sterling, is that the Fed wants to see a significant decline in wage inflation before it is satisfied.
Signs of slowing wage growth in December helped inspire a gain of 700 points for the Dow Jones Industrial Average when the monthly labor market report was released a week ago on Friday. The report showed that the pace of average hourly wage growth over the previous year slowed to 4.6% in December from 4.8% in November. But the markets had already priced this in, the strategists said.
And while that’s certainly better for stock valuations than accelerating earnings, Sterling pointed out that the Atlanta Fed’s earnings tracker is still hovering at 6.4% year-over-year. That will have to come down significantly to satisfy the Fed, he said.
“The Fed needs to see wage growth recede closer to 3% to be confident its job is done,” Sterling said.
To see: Why a stock market obsessed with fighting Fed inflation should focus on Main Street jobs in 2023
Valuations are still too high
Finally, while lower inflation tends to benefit stock valuations, stocks still look overpriced given previous periods of high inflation, said Greg Stanek, portfolio manager at Gilman Hill Asset Management.
“The market likes when inflation goes down, that means a higher multiple,” Stanek said. However, inflation is at 6.5%. That’s still too high to justify paying 17x for the market.
The S&P 500 forward price-to-earnings ratio was 17.3 at Wednesday’s close, down from a recent peak north of 24 in September 2020, according to FactSet data.
Over the past year, US stocks have reacted strongly to CPI data. When October’s CPI figure beat economists’ expectations for a slight decline, the S&P 500 increased by 5.5% in a single day. This is the largest daily gain of the year in 2022.
Granted, markets tend to be forward-looking, as market strategists like to say, and there’s always the possibility that traders’ views on Thursday’s data could shift in the days and weeks ahead. .
In a recent analysis, a Deutsche Bank strategist examined the reaction of US equities to inflation data released over the past two years. He found that the market reaction becomes more confused over time.
While inflation has turned higher than expected, more than it has been lower over the two-year period, “performance has been a bit more hit-and-miss than one might have expected” , said Jim Reid, head of thematic research at Deutsche Bank, in a note released ahead of the data on Thursday.
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“In April 2022, the downside miss in the March reading saw a -9% selloff in the following month, while the same result for the October 2022 data released in November saw a rally of + 7% after the data was released on Nov. 10, Reid says.
Stocks ended with modest gains on Thursday, along with the S&P 500
spx,
up 13.56 points, or 0.3%, to 3,983.17, while the Dow Jones Industrial Average
DJIA,
gaining 216.96 points, or 0.6%, to 34,189.97, and the Nasdaq Composite
COMP,
rising 69.43 points, or 0.6%, to 11,001.10.
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