Inflation data is no longer the big catalyst for stocks that it once was.
U.S. stocks rose to a higher close on Thursday, even as investors received some encouraging inflation news after the consumer price index for December showed its first monthly decline since the pandemic swept the globe in 2020.
Given that inflation has been one of the biggest challenges for markets over the past year, investors might have expected stocks to take off.
Instead, stocks ended Thursday with modest gains after an earlier rejection, the magnitude of which was much smaller than other recent CPI release days.
Although the monthly CPI fell 0.1% in December, the annual rate fell for the sixth month in a row, from 7.1% to 6.5%. That’s the lowest level in more than a year and down 9.1% from last summer’s 40-year peak.
Despite the economic stage, MarketWatch gathered insights from market strategists on what’s going on to better understand what’s driving such a muted reaction in stocks.
Perhaps the main reason stocks were disappointed with the CPI data was that investors were positioning for inflation to come down even more aggressively. Some even hoped the decline would be big enough to prompt the Federal Reserve to reconsider further rate hikes.
Prior to the CPI data for October and November, economists had really underestimated the extent to which price pressures had declined year-over-year. As prices of commodities such as used cars, oil and other commodities fell late last year, traders expected they could turn very conservative again in December.
As a result, a “whisper figure” shared among market experts suggested that core inflation, the Fed’s main focus, would slow faster than economists expected, according to Bill Sterling, global strategist at GW&K Investment Management.
Instead, the core level, which excludes volatile food and energy prices, rose 0.3%, in line with the median forecast of economists polled by The Wall Street Journal.
Options traders were very optimistic
Options traders have been betting that stocks will rise as the release of CPI data approaches in recent weeks, according to Charlie McElligott, managing director at Nomura, which tracks options flow in a note shared with clients and reporters.
Shortly before the data was released, McElligott said stocks could be “set up for disappointment” if the data came in “just in line” with expectations.
As MarketWatch reports, traders are increasingly using options to trade CPI reports and other closely watched data releases.
The report didn’t move the needle
After the CPI report, several market commentators noted that the data did not fundamentally change expectations about where interest rates will peak or how quickly the Fed will move from raising rates to cutting them.
After the report, interest rate futures traders are betting that the Fed is more likely to slow its pace of rate hikes to 25 basis points in March. While they previously saw such a move as extremely unlikely, they now see it as a virtual certainty.
But expectations about when the Fed might start cutting rates were relatively unchanged, with traders continuing to expect the first cut to come in the fall.
Perhaps the biggest reason for this, according to Sterling, is that the Fed wants to see a significant slowdown before it settles on wage inflation.
Signs of a slowdown in wage growth in December helped fuel a 700-point gain for the Dow Jones Industrial Average when the monthly labor market report was released a week ago on Friday. The report showed that the growth rate of average hourly earnings fell to 4.6% in December from 4.8% in November compared to the previous year. Markets have already priced this in, strategists say.
And while that’s certainly better for capital appreciation than accelerating wages, Sterling noted that the Atlanta Fed’s wage tracker is still running at 6.4% annually. That would need to drop significantly to satisfy the Fed, he said.
“The Fed needs to see wage growth pull back to about 3% to make sure it’s done,” Sterling said.
To see: Why should the stock market care about Main Street in 2023 amid the Fed’s inflation fight?
Valuations are still very high
Finally, while low inflation has benefited stock valuations, stocks still look too rich based on previous periods of high inflation, said Greg Stanek, portfolio manager at Gilman Hill Asset Management.
“The market likes when inflation goes down, which means higher multiples,” Stanek said. “However, inflation is at the level of 6.5%. This is still too high for the market to justify paying 17x.”
The forward price/earnings ratio for the S&P 500 was 17.3 as of Wednesday’s close. Versus the last peak north of 24 in September 2020, according to FactSet data.
Over the past year, US stocks have reacted strongly to CPI data. The S&P 500 rose 5.5% on the day when the October CPI figure beat economists’ expectations for a modest decline. It was the biggest daily gain of the year in 2022.
To be sure, markets tend to be forward-looking, as market strategists say, and there’s always the possibility that traders’ views on Thursday’s data could evolve in the coming days and weeks.
In one recent analysis, a Deutsche Bank strategist examined the reaction of US stocks to inflation data released over the past two years. He found that the market’s reaction has become more mixed over time.
Jim Reid, head of thematic research at Deutsche Bank, said that while inflation was lower than expected for two years, “the performance was a little more random than expected.” The note was released before the data on Thursday.
“In April 2022, the decline from the March reading saw a -9% decline over the next month, while the same result for the October 2022 data released in November saw a +7% increase after the November 10th data release. Reid said.
Stocks ended Thursday with the S&P 500 SPX modestly higher,
The Dow Jones Industrial Average DJIA rose 13.56 points, or 0.3%, to 3,983.17.
Up 216.96 points, or 0.6%, to 34,189.97 points and the Nasdaq Composite COMP,
It rose 69.43 points, or 0.6%, to 11,001.10.