Summary
- The rate of inflation continues to decline, but it is likely falling too slowly to encourage the Fed to shift their monetary policy stance from tightening to easing any time soon.
- Stocks have been remarkably resilient in the face of this increasing reality.
- Segments outside of the stock market are signaling mounting near-term pressures against stocks continuing to hold their ground.
The latest reading on inflation was released on Tuesday morning. On the surface, the report for the month of January seemed generally unmoving. The annual rate of inflation did not come down as much as expected, but it still edged lower. And this latest pricing data was not nearly as bad as some market watchers feared heading into the announcement. The stock market reaction during Tuesday’s trading reflected this mixed report, as the large cap S&P 500 and small cap Russell 2000 ended marginally lower for the day, while the NASDAQ and the mid-cap edged higher. Given this general indifference to a middle of the road inflation report, why on the world am I writing about it? Because I have concerns about the accumulating market response I am seeing building under the surface.
Falling slowly. Yes, the rate of inflation did come down in January, but barely. In December, the headline inflation rate as measured by the Consumer Price Index (CPI) was an annual 6.44%. A month later, it crept lower by 10 basis points to 6.34%. As for the core inflation rate excluding the more volatile food and energy components, it did incrementally better in sliding by 15 basis points from 5.70% in December to 5.55% in January.
Disinflationary progress indeed, but here’s the problem. The rate of inflation is falling, but it is falling too slowly and still remains notably elevated at its highest levels in more than 30 years. In other words, inflation may be going away, but it’s not happening fast enough.
What are the implications? Whereas investors just a few weeks ago expected the Fed would be done hiking rates by March, the market is now pricing in two additional quarter point rate hikes in May and June. And while investors are still clinging to the hopes that the Fed will be back to cutting interest rates by December, I remain inclined to take the other side of this bet given the evidence that persists associated with inflation that does not appear ready to fully quit anytime soon.
All the more for that. For a stock market that seemingly pinned its bear market rallying hopes on a U.S. Federal Reserve soon ending its rate hiking cycle and eventually shifting to rate cuts, it has taken the recent barrage of discouraging news on this front notably well.
After failing in its initial breakout attempt above its ultra long-term 400-day moving average resistance, the S&P 500 has been consolidating nicely with only a marginal decline thus far that continues to hold above the downward sloping trading channel that defined the stock bear market for more than a year.
This raises the question as to whether stocks are getting their post Great Financial Crisis mojo back where the propensity to climb persisted regardless of whether the news was good, bad, or ugly.
The good news for U.S. large cap stocks is that their recent upside move is being supported by its mid-cap and small cap brethren. U.S. mid-cap stocks as measured by the S&P 400 Mid Cap Index led the breakout by the S&P 500 by a couple of weeks in January. And the mid-cap rally burst the index well above its key 400-day moving average resistance by late January.
Trends on the U.S. small cap front have been notably similar to mid-caps.
Given that mid-caps and small caps have traditionally led large caps to the upside, particularly at the ends of historical bear markets, this bodes well for potential further upside in stocks after this recent period of consolidation.
We’ve still got time. While I respect the strength and resilience seen across the stock market in recent weeks, I have concerns about the signals that I’m seeing accumulate from other asset classes outside of equities.
Let’s begin with the U.S. Treasury market. One of the keys to support a sustained stock market rally is that long-term U.S. Treasury yields need to be falling. Why? If yields are rising, they further narrow an equity risk premium that is already tight given the historically high valuations that persist among U.S. stocks despite a more than year-long bear market in prices.
So what’s taking place today? After trending lower dating back to last October, both 10-year and 30-year U.S. Treasury yields broke above their downward sloping support lines in recent days (if yields are falling, prices are rising, and vice versa).
While these breakouts may be a temporary blip, if it continues it implies that while the bond market may remain convinced that the Fed will eventually win its inflation fight, it is becoming increasingly concerned with how much inflation might stick around as it gradually fades away.
The precious metals market is also signaling potential challenges ahead for U.S. stocks. Both U.S. stocks and gold have been riding the same Federal Reserve roller coaster over the past year, sharing the hopes and expectations that the Fed would soon top out with rate hikes and eventually turn an eye toward cutting rates. But since the start of February, gold has turned definitively to the downside while stocks remain largely elevated.
The same can be said for silver, which had been holding its ground for much of December and January before finally relenting to the downside since the start of the month.
Bottom line. The U.S. stock market remains remarkably resilient in the face of accumulating evidence that while inflation pressures are subsiding, they are likely falling too slowly to lead to the easier monetary policy outlook required to sustain still historically high valuations. The latest CPI readings from the U.S. Bureau of Labor Statistics provided added confirmation in this regard on Tuesday. And both the U.S. Treasury and precious metals markets appear to be signaling that more challenges may lie ahead for stocks in the near-term.
Given these building downside risks for stocks, it remains worthwhile to maintain a defensive bent in portfolio allocations. This includes favoring more discounted industries such as pharmaceuticals and food that can continue to perform well in such an environment while leaning away from still richly valued segments such as information technology and communication services.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. Great Valley Advisor Group and Stonebridge Wealth Management are separate entities.
This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice. Third party posts found on this profile do not reflect the views of GVA and have not been reviewed by GVA as to accuracy or completeness.