Will the inflation bounce continue for US stocks?

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Goldman Sachs expect inflation to head lower, with bulls hoping to see a recovery for equity markets in anticipation of further CPI weakness

Source: Bloomberg

 

 

 Joshua Mahony | Senior Market Analyst, London | Publication date: Monday 14 November 2022 

Inflation data emboldens the bulls

Last week saw a welcome decline in both headline and core inflation out of the US, with risk assets seeing sharp upside in response. Chief amongst those gaining ground was the Nasdaq, with the tech-focused index proving to be at the riskier end of the investment spectrum given how far prices had extended throughout the bull market. This provides a predicament for traders, with many questioning whether this is the beginning of a protracted equity market rally, or simply a short-term rebound before the sellers come back in to drive prices lower once again. There are two main factors to consider here. Firstly, does this recent decline in inflation represent the beginning of a trend that will ultimately drive inflation back down towards ‘normal’ levels? Secondly, what will the Federal Reserve do in response to this data going forward? Interestingly, we have seen Goldman Sachs emerge over the weekend with a positive message. The investment bank has come out predicting a “significant” decline in US inflation next year thanks to easing supply chain constraints, slowing earnings growth, and a peak in shelter inflation. The bank therefore sees core PCE inflation falling back to 2.9% (from 5.1%) by the end of 2023. While such a reading would still remain above target, there is a good chance that a continued decline in inflation does improve sentiment as traders buy the dip in anticipation of a pivot back towards monetary easing from the Fed. The chart below highlights how things currently stand, with the decline in headline inflation the most pronounced. Aside from that dominant CPI figure, we can see that many of the other measures are yet to show any protracted move lower.

The second question centres around whether the Federal Reserve are going to change course anytime soon. This has also come back into the limelight over the weekend, with Fed member Christopher Waller providing the latest view on this inflation data. Waller reiterated what many of his colleagues have stated on the pace of hikes, with the Fed likely to slow from the 75-basis point moves seen over the past four-meetings. However, it is notable that he also stated that the FOMC will likely remain persistent in their desire to drive down inflation rather than look to cut rates too soon. That highlights the risk that we will see a significant contraction over the coming quarters in a bid to ensure we do not see a secondary wave for prices.

For indices, we are looking at a potential period of optimism as inflation drifts lower. However, those year-end gains would come with a warning that any stalling or reversal of that downward trend for inflation could see fear come back into play. Remember that much of the recent CPI decline has been driven by the elements stripped out by the core reading (energy and food). Thus, any significant uptick in energy prices could see markets turn swiftly lower again as inflation expectations turn upwards. In either case, the Nasdaq looks to be the key market here, with the index likely to benefit the most from renewed optimism and suffer the most when sentiment takes a turn. The wider bearish trend highlighted by the black lines has come back into play after last week’s break through the 11660 resistance level. That double bottom formation brings an improved chance of a recovery phase that takes us back towards trendline, 200-SMA, and deep Fibonacci resistance (12465-12945). However, it is worthwhile noting that the wider bearish trend does still remain intact unless price breaks through the 13722 swing-high. As such, it does appear to be the case that the near-term optimism highlighted by the Goldman Sachs view that we are on a new downward trajectory could drive prices higher towards year-end. However, keep a close eye out for uptick in inflation or energy prices as a potential driver of further downside.

Source: ProRealTime