Markets Rally on Inflation Data
In this article we review:
- Important points to consider following the encouraging October consumer price index report
- The report's potential impact on the Fed's December meeting and our outlook for more rate hikes in 2023
- The potential impact of declining corporate earnings growth for stocks in the year ahead
- Our favorable outlook for high-yield and investment-grade bonds in the current environment
Stocks rallied strong and yields fell on lower-than-expected inflation data released on November 10 as the October consumer price index (CPI) report displayed a year-over-year headline reading of 7.7% and a core (ex food and energy) measure of 6.3%. Both metrics declined from their previous September reports of 8.2% and 6.6%, with headline CPI posting its lowest level since January. Markets reacted enthusiastically to this data, as the S&P 500® rose by more than 200 points (5.5%) and the 10-year U.S. Treasury dropped by 0.33% to 3.81%.
In regard to this development, we believe the following points are important for investors to consider:
- The market’s favorable reaction to these numbers was widely based on the notion that the report could be representative of peak inflation now being in the rearview mirror; however, we caution that one month’s data does not a trend make. Nonetheless, we are encouraged by this report.
- We believe the Federal Reserve will likely need to see a series of similar declines in the rate of inflation before taking a pause on rate hikes. That said, there is probably enough in this report to swing the probability more in the direction of a 0.5% rate increase at the upcoming December meeting, taking the federal funds rate to a target range of 4.25%–4.5% to close out the year.
- From there we see the Fed still moving to a 5% lower bound on the fed funds rate during 1Q 2023 before likely taking a pause and letting higher rates filter through the economy as core inflation potentially moves toward 4% by midyear.
- From a technical standpoint, while the higher move in stocks is certainly welcome, we caution that unless it extends beyond approximately 4,300 on the S&P 500 in the weeks ahead, this activity should probably still be considered a bear market rally as it would continue a pattern of lower highs and lower lows.
- An increasing focus for stocks in the months ahead will be CY 2023 corporate earnings estimates, as the official 2023 aggregated bottoms-up Net Operating Earnings Estimates on the S&P 500 (FactSet Earnings Insight) is still calling for about 5% growth. This, in our view, is clearly too high, as we believe earnings for the year ahead will likely come in about 5%–10% lower than CY 2022 or perhaps even worse, given a high probability of recession during the year ahead.
- Lower earnings in 2023 have, in our view, already been discounted to some extent in stock prices, but their actual occurrence will need to be balanced out with other variables such as the degree of economic slowing, an eventual fed pause, and potentially lower rates of inflation.
- We continue to have a favorable outlook on investment-grade and high-yield bonds, where we believe dramatically higher yields since the year began now represent strong opportunities, particularly if inflation rates decline and a severe recession (as opposed to a moderate one) is averted in the year ahead.
In summary, we believe markets are likely to remain volatile in the months ahead as investors seek clarification on the pace of inflation and Fed rate hikes, economic slowing, and the risk of recession as well as corporate earnings and their potential impacts on stock valuations. Amid this ongoing uncertainty, we continue to believe there are immediate opportunities in investment-grade and high-yield bonds and longer-term opportunities in the equity markets looking out about one year or longer.
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