Inflation data may not be the biggest catalyst for stocks as it used to be.
US stocks rebounded near a close higher on Thursday, although investors got some encouraging inflation news after the consumer price index for December showed its first monthly decline since the pandemic swept across the globe in 2020.
Given that inflation has been one of the most important issues for the markets over the past year, investors might expect stocks to take off.
Instead, after an earlier concession, shares ended Thursday with modest gains, an order of magnitude smaller than in recent CPI release days.
While the monthly CPI fell 0.1% in December, the annualized measure fell for the sixth consecutive month to 6.5% from 7.1%. This is the lowest in more than a year and down from a 40-year peak of 9.1% last summer.
To get a better understanding of what led to such a subdued stock reaction, despite the economic achievement, MarketWatch gathered insights from market strategists on what happened.
Perhaps the main reason stocks received the CPI data with disappointment was that investors took a stand for lower inflation more aggressively. Some even hoped the drop would be large enough to prompt the Federal Reserve to reconsider further rate hikes.
Prior to the October-November CPI data, economists had already underestimated the degree to which price pressures were easing, on a year-on-year basis. And with prices of commodities such as used cars, oil and other commodities falling late last year, traders speculated that they might be very conservative again in December.
As a result, the “whisper number” common to market professionals suggests that core inflation — the Fed’s main focus — will slow faster than economists had anticipated, according to Bill Sterling, global strategist at GW&K Investment Management.
Instead, the core level, which omits volatile food and energy prices, rose 0.3%, matching the median forecast from economists polled by the Wall Street Journal.
Options traders were very optimistic
Options traders have bet that stocks will rally in recent weeks as CPI data looms, according to Charlie McElligott, managing director of cross-asset strategy at Nomura, who compiled data on option flows in a note shared with clients and reporters.
Shortly before the data was released, McClegott said stocks could be “set to be disappointed” if the data came in “fully in line” with expectations.
Traders have increasingly used options to trade CPI reports and other closely watched data releases, as MarketWatch reported.
The report did not move the needle
Many market commentators noted in the aftermath of the CPI report that the data did not fundamentally change expectations about where interest rates will peak, or how quickly the Fed will shift from raising rates to lowering them.
After the report, interest rate futures traders bet on increasing odds that the Fed will slow its rate hike to 25 basis points in March. Although they previously saw such a move as very likely, they now see it as a reality.
But expectations for when the Fed will start cutting rates are relatively unchanged, with traders still anticipating the arrival of the first cut in the fall.
Perhaps the biggest reason for this, according to Sterling, is that the Fed wants to see a significant easing of wage inflation before it will be satisfied.
Signs of slowing wage growth in December helped add 700 points to the Dow Jones Industrial Average when its monthly labor market report was released a week ago on Friday. The report showed that the pace of growth of average hourly earnings over the previous year slowed to 4.6% in December from 4.8% in November. But strategists said the markets had already appreciated that.
And while it’s certainly better for stock valuation than accelerating wages, Sterling noted that the Atlanta Fed’s wage tracker is still running at 6.4% year over year. He said that would need to drop significantly to satisfy the Fed.
“The Fed needs to see wage growth fall back to close to 3% to be convinced that its mission is accomplished,” Sterling said.
We see: Why a stock market obsessed with the battle for federal inflation should focus on Main Street jobs in 2023
Ratings are still very high
Finally, while low inflation tends to benefit stock valuations, stocks still look very expensive based on previous periods of high inflation, said Greg Stanek, portfolio manager at Gilman Hill Asset Management.
“The market loves when inflation goes down, it means a higher multiple,” Stanek said. However, the inflation rate was 6.5%. That’s still too high to justify paying 17 times the market.”
The forward price-to-earnings ratio for the S&P 500 was 17.3 as of Wednesday’s close, versus a recent peak north of 24 in September 2020, according to FactSet data.
Over the past year, US stocks have shown a strong response to CPI data. When the October CPI number beat economists’ expectations for a modest decline, the S&P 500 rose 5.5% in one day. The biggest daily gain of the year was in 2022.
Markets certainly tend to be forward-looking, as market strategists like to say, and there is always the possibility that traders’ opinions on Thursday’s data will evolve in the days and weeks ahead.
In a recent analysis, a Deutsche Bank strategist examined the reaction of US stocks to inflation data released over the past two years. He finds that the market reaction becomes more confusing with time.
While inflation came in more than expected more than it was in the two-year period, Jim Reid, head of thematic research at Deutsche Bank, said in the release of the note ahead of the data on Thursday.
“April 2022, the downward dip in the March reading saw a sell-off of -9% over the following month, while the same result for October 2022 data released in November saw a rise of 7% after the data was released on November 10,” Reed said.
Stocks ended with modest gains on Thursday, with the S&P 500 SPX,
It rose 13.56 points, or 0.3%, to 3,983.17, while the DJIA Dow Jones Industrial Average rose,
Gaining 216.96 points, up 0.6%, to 34,189.97 points, the Nasdaq Composite Index.
up 69.43 points, or 0.6%, to 11,001.10.