Inflation, once considered a curse for the stock market, has transformed into an unlikely ally, fueling the current rally. A year after inflation sent shockwaves through the US stock market, investors now view it as Exhibit A for those betting on the continuation of this year’s upward surge.
Following an alarming surge of 9.1% in the consumer price index (CPI) in June 2022, inflation has gradually receded amid the Federal Reserve’s relentless monetary policy measures. Economists predict that the Labor Department’s upcoming report will indicate a mere 3.1% increase in the index for last month, marking the smallest annual rise since March 2021.
The slowdown in inflation has contributed to the positive performance of the stock market this year, leading to speculation that the Federal Reserve is approaching the conclusion of its campaign, despite the possibility of a few upcoming rate hikes.
This optimism is backed by a significant historical trend: data from the Leuthold Group reveals that since the 1950s, inflation peaks have often been followed by double-digit gains in the equity market.
Adam Sarhan, founder of 50 Park Investments, has expressed his belief in the Federal Reserve’s effectiveness in combating inflation, stating, “The indications suggest that the Fed is successfully addressing the challenge of inflation.” Sarhan also added, “My current approach assumes that we are at the initial stages of a new bull market unless substantial weaknesses emerge to suggest otherwise.”
As long as inflation remains under control and the Fed maintains its cuGiven that inflation stays within manageable levels and the Federal Reserve continues to maintain its current position on interest rates, this creates a favorable prospect for investing in stocks.
Since reaching its lowest point in October, the S&P 500 Index has experienced a remarkable surge of over 20%, demonstrating a substantial 15% rise since the release of the peak CPI data in July 2022. The tech-heavy Nasdaq 100 Index has experienced an even more impressive climb, rising 40% from its lows last year, fueled in part by the excitement surrounding advancements in artificial intelligence.
The Fed’s Battle and Market Expectations
The key factor propelling the market’s upward momentum is the optimistic outlook that the Federal Reserve will be able to wind down its monetary policy campaign, primarily driven by the expectation of alleviating inflationary pressures. This campaign has resulted in a gradual increase in the benchmark interest rate from near zero in early 2022 to its current range of 5% to 5.25%.
As Fed policymakers enter a silent period, traders eagerly anticipate the release of the CPI figures this week, seeking insights into the central bank’s future trajectory. The latest jobs report, indicating a slight slowdown in a robust labor market, has set the stage for market movements leading up to the central bank’s rate decision on July 26, followed by Chair Jerome Powell’s subsequent press conference.
Despite the prevailing optimism, it is essential to acknowledge that risks persist for the stock market. Traders have repeatedly postponed predictions about the timing of the Fed’s rate peak as the economy has outperformed expectations. A number of Wall Street strategists hold a pessimistic view, foreseeing a potential decline in the market during the latter half of the year due to a slowdown in economic growth.
Inflation’s Impact on the Stock Market
Furthermore, the unexpectedly robust wage growth observed in June is expected to reinforce the Federal Reserve’s commitment to raising interest rates this month. Traders are currently assigning a high likelihood of another rate increase later in the year. Any indication that inflation remains persistently elevated may exert pressure on overvalued segments of the stock market, particularly technology companies, which have propelled the Nasdaq 100 to trade at around 29 times projected earnings.
Cheryl Smith, portfolio manager and economist at Trillium Asset Management, urged caution in the short term, stating, “AI will be a significant factor for investors over the next decade, but carefulness is required in the immediate future,” citing the risk of an impending recession.
Nevertheless, strategists at Wells Fargo Securities maintain that the Federal Reserve’s monetary policy tightening is expected to yield positive results on the inflation front. They draw attention to the strong correlation between changes in consumer prices and the M2 money supply, a widely used measure. As M2 continues to contract, they anticipate a continued decline in inflation as it diminishes demand in the economy.
Chris Harvey, head of equity strategy at Wells Fargo, emphasized the relationship between liquidity and inflation, stating, “More liquidity is associated with inflation growth and vice versa. M2 has been contracting for over a year and is still contracting, though at a decelerating rate. If the economy continues on its current trajectory and inflation subsides, this will support higher equity prices.”
Inflation, once seen as a stock market curse, has taken on a new role as an ally in the current rally. The gradual decline in inflationary pressures has provided support to the stock market, fostering optimism that the Federal Reserve is effectively combating inflation. While risks persist and market dynamics are subject to change, investors are capitalizing on the opportunity presented by a controlled inflation environment and the Federal Reserve’s current stance on interest rates.