ACTV - Stocks Can Rally As The 'Higher For Longer' Interest Rates Narrative Collapses

2023-03-15 22:40:27 ET

Summary

• A surprise lower in the February PPI and room for inflation to trend lower going forward is a favorable development.
• The banking industry turmoil has opened the door for the Fed to pause at the next FOMC, taking a more cautious approach.
• Stocks can rally with lower rates and declining inflation as a tailwind for risk assets.

It was just one week ago when Fed Chairman Powell in his semi-annual testimony to Congress explained that economic conditions were "stronger than expected," making the disinflationary process more difficult. This followed an exceptional jobs report and January CPI data that surprised the upside. The takeaway then was that the interest rates would need to climb further than previously expected.

Fast forward, it's not an exaggeration to claim a lot has changed in just a short time frame. The ongoing banking industry turmoil from the fallout of SVB Financial ( SIVB ) and Signature Bank's ( SBNY ) failure has created a new set of challenges for the Fed that was likely not even on their radar a few weeks ago. Market confidence has been shaken translating into ongoing volatility in both bond and equity markets right now.

At the same time, there is some cold water on the inflation is too hot narrative. In our view, economic conditions have gotten just enough of a hit to pull back demand-side inflationary pressures with room for the CPI to trend lower and fast going forward. We're on the side that the next Fed will keep rates steady at the upcoming March 22nd FOMC and is done with this hiking cycle. This scenario may help stabilize market conditions and ultimately set up a rebound in stocks and risk assets.

A Setup for the Fed to Pause

The tectonic market shift over the past week is evident in the current expectations for the Fed's next step in policy action at the March 22nd FOMC. According to the CME " FedWatch Tool ", which quantifies the market-implied expectation, rate futures now suggest a near 60% chance the Fed will not hike at all. For context, a week ago there was a 79% chance for a 50bps point hike with that scenario now at 0%.

This type of move explains a lot of the fear in the market right now considering the higher degree of uncertainty in everything from the direction of rates, the strength in the economy, the impact on corporate earnings, and also the outlook for inflation itself.

The good news is that inflation may no longer be the problem it was previously perceived. Sure, the latest February CPI largely came in at the consensus, climbing +0.4% from January and up 6% year-over-year is still too high, but what's more important is the forward outlook.

If there were any voting members among the Fed board of governors that were on the fence last week between a 25 basis point hike, or a 50 basis point move, our thinking is that the circumstances now are enough to take an even more cautious approach with a pause. So what we have here is a good backdrop for the Fed to keep rates unchanged, at least with a wait-and-see approach, more focused on the implications that higher rates can add to financial system stress.

Inflation is Done

By all accounts, the setup now has the risk tilted for inflation to surprise lower in the coming months. Recognizing that the banking industry's "turmoil" or crisis is a net negative on economic conditions, some softer trends in broader activity indicators and even consumer confidence should work to limit inflationary pressures from here.

Companies pulling back on hiring, or even announcing new layoffs will likely be reflected in softer labor market trends and also lower wage growth as new development.

We can go through each category of the CPI and point out which items are "sticky" and still stubbornly high, but there is no reason to expect those drivers to re-accelerate. Just look at the trading action in commodities across energy, agriculture, and industrial metals. The price of oil ( USO ) under $70/bbl is now down nearly 50% from its 2022 high when it briefly traded above $130/bbl this time last year.

If companies were using those cost-side factors as justifications to hike prices on goods and services last year, looking at the charts below, the environment is more deflationary in this regard.

In other words, the soft patch of economic conditions that has emerged is a favorable twist to the Fed's mission to get the CPI moving lower. Case in point, the latest producer price index ((PPI)) for February surprised sharply lower, declining by -0.1% on the month compared to a consensus increase of +0.3%. The annual rate also fell to 4.6% from 5.7% last month.

Looking ahead to the March CPI data reported in April, a scenario where that data comes in cool and reverses some of the higher trends in recent months can work as a confirmation that inflation will trend lower faster going forward. This would provide the Fed some flexibility in its messaging, and even open the door for rate cuts down the line as it becomes evident trends in consumer prices can justify it.

Even stepping back from the banking industry situation, it's possible the "blip" higher in the January CPI was an outlier and the structural disinflation was on track to continue regardless. Even the survey of inflation expectations for the year ahead had dropped sharply to 4.2%, with the polling done before the bank's firestorm.

The bigger takeaway here is that further rate hikes by the Fed are unnecessary for continued declines in the annual inflation rate. Consider that the current level of interest rates has already tightened credit conditions, particularly in segments sensitive to consumer credit with the transmission effect ongoing.

This could play out in lower vehicle prices and shelter components of the CPI with current prices simply being unaffordable. We're also watching credit card delinquencies tick higher that is limiting consumer demand from here.

Again, while the path is not yet quite to the 2% target, no one would claim inflation is "out of control" approaching an annual rate of 3% into 2024. That's the light at the end of the tunnel investors can look forward to.

Stocks Can Rebound

The next step for the market will be to rebuild confidence and shift the narrative over the next few months that inflation is under control. Easing financial conditions should be positive to establish a sense of stability.

The key assumption here is that systemic risks from the banking sector are contained and there is no major credit evident based on some large-scale corporate default. As long as economic conditions remain resilient averting "surging" unemployment or major contraction in consumer spending, risk assets have an appeal of improving macro conditions.

As it relates to the S&P 500 ( SPX ), lower inflation and lower interest rates can remove what were two of the biggest headwinds over the past year. A major theme in recent months has been the move by companies to cut costs and support margins, these efforts can work to sustain earnings which could play out over a solid Q1 reporting season.

In the near term, it will be important for the S&P 500 to hold what we believe is a key area of technical support around $3,800 and the market low from last October. Climbing firmly back above $4,000 can put the bulls back in control targeting $4,200 as the first upside target.

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