Stock market recovery in 2023 depends on how quickly inflation declines

Behind the good start of the year in the markets, there is a widespread bet that inflation will soon record one decrease in its generation.

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Market-based measures show expectations that the annual rate of inflation will fall in the coming months about as fast as it fell during the recession that followed the 2008 financial crisis — or when Federal Reserve Chairman Paul Volcker used double-digit interest rates in the late 1970s to crush the rampant inflation.

Hopes for a quick return to 2% inflation fueled bets that the Fed would halt and even reverse course on rate hikes this year. Interest rate hikes hurt stocks and bonds in 2022, and a possible reprieve caused both types of securities to rise in January. The rally spread to some of the riskier assets that hit investors the hardest last year, such as bitcoin and the hedge fund ARK Innovation, known for its focus on growth companies in the technology sector.

Stock gains continued on Monday this week, with the S&P 500 index rising 1.2%, led by gains in the technology sector. The technology-biased Nasdaq rose 2%, bolstering the recovery of stocks that suffered the most when interest rates rose last year.

But many Wall Street strategists warn that it will be difficult to bring high inflation to a painless end. Previous episodes of inflation suggest that it rarely falls as quickly as markets now predict it will fall without a major recession.

In the meantime, the markets remain stable

Economic data released last week showed signs of weakening consumer demand. More companies are laying off workers and cutting their earnings estimates. But in the meantime, the reopening of China’s economy, and the still-tight labor market, are both adding to inflationary pressures that could cause the Fed to raise interest rates above the levels currently expected.

Avoiding a significant pullback while inflation is falling rapidly will require an economic “golden and three bears scenario,” said Liz Ann Saunders, chief investment strategist at Charles Schwab. “Pretty much everything will have to be just the right size,” she said.

For now, the markets remain relatively stable. Although the S&P 500 fluctuated last week, it is currently up 4.7% in 2023 (as of Monday’s close). There was also a rally in bonds. US bond yields and derivatives markets both reflect bets that the CPI will rise by about 2% by next January.

As of the close of trading on Monday this week, Treasury bonds maturing in January 2024 yielded about 4.7%, while Treasury inflation-protected bonds maturing in the same month yielded about 2.7%, according to Tradeweb. The difference between these figures, known as the break-even inflation rate, shows that people who trade in Treasury bonds are betting that the consumer price index will rise by about 2% in the next 12 months.

Bets on CPI swaps, which are another way to bet on future inflation rates, show traders are expecting inflation of around 2.2% next year.

These figures, if realized, will reflect a historic speed in the decline of inflation.

In June, the annual increase in the consumer price index reached 9.1%, the highest index since the early 1980s. If inflation drops to 2% by next January, this drop of about 7% will be almost exactly equal to a similar drop that happened between August 2008 and July 2009, when inflation dropped to minus 2.1% from 5.6% – in the middle of a historic recession.

Before that, inflation had not fallen this fast in 20 months since Volcker’s rate hikes in the early 1980s. The previous episode happened when the economy was returning to normal after the start of the Korean War.

Bob Michel, chief investment officer at J.P. Morgan’s asset management division, cautioned that it is too early to assume that inflation will continue to decline in an orderly fashion later this year. If it starts to climb again, the Fed can go back to raising interest rates, he thinks. Michel tells his clients to avoid investing in debt that is sensitive to interest rate increases.

“There are a lot of reasons for the Fed to pause to see what happens, but there are also a lot of reasons that they will have to keep raising interest rates,” Michel said.

Monica Difand, director of the research institute of the asset management company Amundi, also fears that the consensus about inflation is too optimistic. It expects the annual rate not to fall below 4% in the next 12 months. Amundi advises clients to take a cautious approach to the stock market. “We do not believe that 2% is an achievable goal at this time,” she said.

Since 2021, traders’ bets on inflation a year ahead have consistently delivered too low estimates of how quickly prices will rise. Last year’s surprise rise in inflation caused the Fed to rush to moderate rising prices, encouraging the central bank to raise interest rates in a way that caused the Nasdaq index to drop 33% in 2022.

But the past three months have brought renewed optimism about cooling inflation, and predictions that the Fed will stop raising interest rates as early as March. Inflation was 6.5% in December, the lowest since the end of 2021. The Fed slowed the pace of rate hikes that month, and most expect it to do so again on February 1.

In the meantime, even Bitcoin registered a rally in 2023

The optimistic assumptions about the way forward helped assets that were hit hard last year to start 2023 on the right foot. The hedge fund ARK Innovation, which bets on growing technology companies, rose by more than 21% this year. The tech-heavy Nasdaq Composite Index, which fell more than other indexes last year, is now overtaking them. Even Bitcoin has rallied, after a terrible year in 2022, and the currency is up 39% against the dollar so far this year.

Even more dormant areas strengthened following assumptions that inflation would end painlessly. Shares in the homebuilding sector have climbed since mid-October, even as Wall Street analysts cut estimates for future earnings in the industry, Saunders Mashwab observed. Last year, interest rate hikes hit the housing market hard, because they made mortgages more expensive.

Analysts who predict that the inflation in the consumer price index will cool down quickly this year point to a large drop in energy prices since the summer, as well as an easing of the increases in the prices of food and some goods in recent months.

But even if inflation falls as quickly as traders now expect, stocks could still run into trouble if the economy goes into recession as inflation falls.

One classic warning signal for a recession has been flashing since the summer. For months, yields on short-term Treasury bonds have been higher than yields on long-term bonds, a reversal of the normal situation and a sign that investors expect slower growth and interest rate cuts in the future.

That gives good reason to question the durability of the current stock market rally, said Chris Verona, director of technical and macro research at Strategas.

“We cannot blindly recommend long-term risk assets when the yield curve does not yet show that we have moved to the other side of this story,” Verona said.

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