The market acts as if the peak of inflation has passed. Not so fast.
Wall Street received a dose of good news this week. He also got a little ahead of himself.
Inflation slowed in July, according to Labor Department data released on Wednesday. The consumer price index rose 8.5% in July from a year ago. That was below both the 8.7% rise in prices forecast by economists and the 9.1% reading in June.
This news sent the
S&P 500 Index
up 2.1% that day and tipped the tech-weighted balance
in a bull market. The S&P ended the week up 3.3%, while the
Dow Jones Industrial Average
and the Nasdaq gained 2.9% and 3.1% respectively.
It makes sense that investors are celebrating price relaxation. But it may be too early to pop the champagne – inflation at 8.5% is still far from the Federal Reserve’s 2% target, and the Fed should continue to tighten until it is under control.
Even if inflation has peaked, it will likely remain stubbornly high. “A good impression will not change the Fed’s modus operandi,” said Richard Bernstein, CEO of Richard Bernstein Advisors. Barrons. “The last thing they want to do is take their foot off the brake and bring inflation back.”
There are several reasons to believe that inflation will continue to be rigid, even if it remains below multi-decade highs. This means that investors could expect greater market volatility through the end of the year. Wednesday’s rally was widely seen in tech names and other more speculative assets like cryptocurrencies, which is not what one would expect in a tightening cycle.
“The more you think the technology is going to work, the more you have to think the Fed is going to have to tighten,” Bernstein says, as it indicates a speculative mindset that’s not compatible with a slowing economy, which is also seen in other economic data.
July’s jobs report beat economists’ expectations and showed that labor demand remains robust, which also means companies will likely have to keep paying to retain and attract workers. No one cares about a raise until they realize that the inflationary effects of salary increases leave them pretty much where they started.
There’s the fact that some of this apparent cooling comes as several cities in China are under Covid lockdown, meaning there’s less demand from the world’s second-largest economy.
It’s hard to declare victory over commodity inflation while China is still enforcing its Covid-zero policy, Bernstein warns. “If the Chinese economy is six or eight cylinders and commodities are lagging, we have something,” he says. “We are one or two cylinders.” Indeed, commodity prices rose last week: Brent crude oil flirted with $100 a barrel last week, and copper prices rose.
Given the market’s tendency to pull back after rallies in volatile markets, the risk-reward for getting excited about stocks is now poor, points out Jonathan Krinsky, chief market technician at BTIG.
With markets likely to be volatile for some time as the effect of interest rate hikes and inflation ripples through the system, bet on two things: the Fed will continue to be aggressive and earnings will slow down. Speculative names may be tempting after any dose of good news, but investors are better off sticking to defensive sectors that offer stable growth, such as consumer staples, utilities and healthcare.
These sectors may also experience volatility, but demand will not decline dramatically in a downturn.
Write to Carleton English at [email protected]