AFMC - Falling Inflation Rates Are Not As Good As They May Seem For Stocks

2023-05-10 14:01:53 ET

Summary

• The CPI report came in as expected, and offered no surprises.
• Additionally, there was that post-data release rally as event risk was removed.
• The inflation data offer no clear signs that Fed will be cutting rates anytime soon.

The CPI report brought back volatility, despite being basically in line with expectations. The CPI did not surprise anyone, yet the S&P 500 rose by 80 bps, and implied volatility decreased after the release to start the day. One should expect this trend to continue as we approach the June FOMC meeting and more data is released.

Falling inflation rates are not necessarily beneficial for stocks, and will only be positive if they lead to the Fed cutting rates. However, the current inflation data does not support rate cuts. As inflation declines, it will likely result in slower sales growth, falling margins, and weaker earnings growth, leading to lower PE multiples for stocks.

Inflation Remains Way Too High For Rate Cuts

In April, the CPI increased by 0.4% m/m, in line with estimates, and core CPI also rose by 0.4% m/m, as expected. However, headline CPI increased by 4.9% y/y, slightly below the 5% estimate, while core CPI increased by 5.5%. These numbers are not cause for celebration, as core CPI remains very high and has shown little sign of easing.

More noteworthy is that the non-seasonally adjusted increase for April was 0.5%. When factoring in the rate of change since the beginning of the year, the non-seasonal measure of inflation is accelerating, rising at an annualized rate of 6.9% for the first four months. This is worth watching, as last year, we discovered that seasonal adjustments did not accurately reflect actual inflation, and inflation was higher than previously thought. While inflation has slowed year-over-year, ensuring it continues to slow is essential, even when accounting for seasonality.

No Rate Cuts

Regardless of how the data is analyzed, inflation remains too high, and today's report does not support the market's belief that the Fed should cut rates in 2023. The only positive for the Fed is that there will be one more inflation report just before the June FOMC meeting.

Although the latest data does not indicate a rate cut is necessary, it does not mean another rate hike is needed. The odds of a June rate cut have not changed significantly, remaining at 9%, which is down a few ticks from yesterday's 16%. This suggests that the May jobs and CPI report will carry much weight leading up to the FOMC meeting, especially if the market expects the Fed to pause.

More Volatility

The back-and-forth price action will likely continue and worsen in the coming weeks. Recent data suggest implied volatility increases leading up to major news events and falls after the news is released. Ultimately, market trends will be determined by the economic data and what it indicates.

The VIX 1 Day index is an excellent gauge of short-term volatility. For instance, the VIX 1 Day index rose sharply in the final trading hours yesterday, causing the S&P 500 to decline ahead of the CPI release. Following the report, the volatility index fell significantly as the event risk passed, pushing the S&P 500 to rise. However, the data did not support the idea that the Fed would be cutting rates anytime soon, and as the implied volatility levels reset, the S&P 500 gains disappeared.

The Inflation Tailwind Is Fading

Stocks may not benefit from lower inflation rates because they often translate into lower revenue and earnings growth and do not guarantee Fed rate cuts. For instance, if inflation drops to around 3%, it may not necessarily prompt the Fed to cut rates, but it could indicate a lower sales growth rate. Historically, sales growth has been linked to the inflation rate.

Operating profit margin estimates have contracted significantly over the past several months and currently sit at their lowest point over a year. This could result in further margin compression for companies as they lose the ability to pass on higher prices while their costs remain unchanged. If margins compress and growth stalls, it could lead to multiple compression in the indexes, and the recent round of multiple expansion is likely to diminish.

The market is likely to experience a period where volatility worsens as it tries to figure out whether the Fed will continue to raise rates while also losing the tailwind of high inflation that supported sales growth and helped deliver a slightly better-than-feared first quarter earnings season.

One should expect more wild intraday swings, like those witnessed today and following the Job report, and that will make understanding what is happening more confusing than ever.

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