Investors have spent months wrestling with rising interest rates and dwindling portfolios. No wonder they are desperate for a sliver of good news.
The latest official reading on U.S. inflation delivered those glad tidings on Thursday morning. It showed that the consumer price index (CPI) for October rose 7.7 per cent compared with where it stood a year earlier. That was significantly below the 8.2 per cent annual rate in September and also a hair below most economists’ forecasts.
The U.S. stock market reacted as if it had won the lottery. The benchmark S&P 500 index rocketed 5.5 per cent higher and enjoyed its biggest one-day gain in more than two years.
That was fun. However, the big move upward also looks overdone.
One problem, as you may have noticed, is that October’s 7.7 per cent inflation reading is still a light-year away from the Federal Reserve’s 2-per-cent target for inflation. However you interpret the latest CPI numbers, it is clear that policy-makers still have a long way to go before normality will come back in sight.
The next bull market in stocks is unlikely to resemble the previous one
Another problem is that the October report is just one month’s numbers. Inflation readings have bounced up and down this year and there is no guarantee the next U.S. CPI report, on Dec. 13, will continue the encouraging trend. “Every down month this year … has been followed by a surge the next time,” Derek Holt, head of capital markets economics at Bank of Nova Scotia, warned clients in a note.
So investors are left with a conundrum. Exactly how much weight should they put on this week’s CPI report?
Not as much as they might like to, according to Roberto Perli, head of global policy at investment bank Piper Sandler. A former senior staff member at the Fed, Mr. Perli argues that October’s report is unlikely to significantly change the overall course of the central bank’s policy.
“There was nothing exceptional in the CPI release,” he wrote in a note.
Like Mr. Holt, he pointed out that inflation has been volatile this year, especially if you look at core inflation – that is, inflation stripped of food or energy prices. This is the third time this year that core inflation has ticked in at 0.3 per cent on a month-over-month basis. Both of the previous two occasions were followed by big rebounds in inflation over the subsequent months.
Mr. Perli acknowledges the Fed will probably seize on the October CPI report as reason to slow down the pace of interest rate hikes. The central bank is growing more cautious and will almost certainly choose to bump up its key Fed funds rate by only 50 basis points at its December meeting, rather than the 75 basis points that many had once feared. (A basis point is one hundredth of a percentage point.)
However, the Fed’s ultimate destination shows no signs of changing, Mr. Perli says. It is probably still headed toward a peak Fed funds rate of about 5 per cent, compared with 3.75 per cent to 4 per cent now. It is unlikely to back down until there is compelling evidence that inflation is trending down to its 2-per-cent target.
The futures market agrees with Mr. Perli’s take. According to the FedWatch tool maintained by the exchange operator CME Group, the majority of futures investors see the Fed funds rate touching 5 per cent next July. FedWatch, which is based on the prices of Fed funds futures contracts, sees a 39-per-cent chance that the central bank’s key rate will top out at 4.75 to 5 per cent and a 24-per-cent chance it will hit 5 per cent to 5.25 per cent.
The prospect of higher interest rates over the next few months suggests investors might not want to get carried away by this week’s rally. Analysts at Capital Economics are sticking to their forecast that the S&P 500 will sink from its current level near 4,000. They see it bottoming out around 3,200 by the middle of next year.
“We think today’s equity market rally will reverse course before long,” assistant economist James Reilly wrote in a note Thursday. “This is mainly because we still think investors are not fully discounting the impact of the looming global recession.”
David Rosenberg of Rosenberg Research offered a similar take on Friday. History shows the largest one-day stock market advances occur during bear markets, he wrote in a note to clients. The big rally on Thursday is probably yet another “head fake,” he said. While the surge could continue in the near term, and propel the S&P 500 to around 4,100, it is likely to fade in the following months as the market’s attention turns away from inflation and toward the lacklustre outlook for corporate earnings.
It’s possible, of course, that these gloomy prognostications could be wrong. The past couple of years have demonstrated no one excels at predicting inflation or recessions. Still, it’s worth keeping the warnings in mind. This week’s rally was fun. Ultimately, though, it may not mean as much as you think.