2023-04-12 13:45:00 ET
Summary
- The latest CPI report poured cold water on concerns inflation remains out of control.
- The Fed will likely consider the favorable development to justify ending the rate hiking cycle.
- Stocks can rally higher as interest rates stabilize into a soft landing scenario.
The latest cool inflation data is great news for investors. The March CPI climbed just 0.1% in the month, representing a surprise lower compared to the consensus expectation for a 0.3% increase. The trend was good enough to drop the annual rate down to 5.0%, from 6.0% last month, and also under the 5.2% estimate.
The takeaway here is that the "disinflationary process" is well underway, with the Fed's strategy to stabilize consumer prices working. More importantly, the setup likely provides the data flexibility for the Fed to hold off on further rate hikes, recognizing that increasingly restrictive monetary policy is no longer necessary for the CPI to continue moving lower. A "pause" over the next few Fed meetings can work to support macro conditions and drive market sentiment.
Bullish On Stocks
The theme of moving past peak inflation and the path to a "soft landing" in the U.S. economy explains the rally in the S&P 500 (SP500) over the last several months, more than 16% higher from its 2022 lows. Simply put, macro conditions have evolved better than expected compared to the extreme pessimism with doom-and-gloom predictions last year.
We've been calling the climb in stocks and can reaffirm a conviction today that there is more upside. The update here is simply more bad news for anyone expecting inflation to reaccelerate or calling the Fed to keep hiking higher for longer. SPX can keep climbing as the market resets interest rate expectations lower while companies and corporate earnings benefit from easing cost pressures.
Inflation Is Not A Problem
Going through the March CPI data , a couple of points stand out. Energy is the main component responsible for the annual decline, even deflationary compared to conditions in early 2022. This is in the context of crude oil prices down more than 35% since trading above $130/bbl in Q1 last year.
The dynamic is similar across most commodities including agriculture which ends up getting reflected in slowing food prices, which posted a 0.0% change on the month, the lowest level since November 2020. Within that amount, food at home declined by -0.3% compared to February.
The insight we offer is that cost-push inflationary pressures, defined by companies rushing out to raise prices in an attempt to keep up with rising costs, are notably missing compared to 2022. Even within core items, "services less energy services," climbing 0.4% m/m in March have slowed materially compared to the average of 0.7% over the prior six months.
While there are some price categories like shelter and new vehicles that have stayed high, we'd say those items are just lagging the bigger trend and will slow going forward. The core CPI at 5.6% is favorably down from its peak of 6.6% last year.
All indications are that the headline annual CPI will fall further over the coming months. We see even more downside compared to the current year-ahead inflation expectations, with estimates being revised lower from here.
It would be a mistake to look at inflation in isolation from the broader economy. We mentioned the soft landing scenario as part of the bullish case for stocks. That includes the baseline of a cooling labor market and even acknowledging some weaknesses across different sectors. The Fed has already hiked more than 475 basis points this cycle and the understanding is that some of that tightening transmission is still working through the economy.
So what we have here is a nigh-and-day difference compared to any speculation that inflation was running hot, and the Fed would be forced to keep hiking indefinitely. Getting the CPI under 4% by this time next year may not be quite at the mythical 2% Fed target, but also not a level where anyone can claim consumer prices are out of control.
The Looming Fed Pause
According to the CME " FedWatch Tool ", which captures the implied probability for the next steps in Fed policy based on interest rate futures, the market is currently pricing in a 72% chance for a 25bps hike and a smaller 29% probability of holding the rate steady at the May 3rd meeting.
The latest CPI report helps build the case for a pause right away, with the Fed also eyeing repercussions of higher rates following the recent banking industry turmoil.
That being said, a final rate hike taking the terminal rate to 5.25% would still be consistent with the recent messaging by Fed Chairman Powell that rate hikes are "near an end". This move would provide some continuity to the cautious approach to inflation the group has maintained over the past year. The Fed could use the opportunity to project some confidence in the direction trends are moving and signal its intention to hold rates steady through the June and July meetings.
As it relates to risk assets and the stock market, both directions can still be supportive for the bullish case, recognizing that the underlying hard data is moving in the right direction. The economy managed to absorb 475bps of tightening since 2022, and a final tick higher here should not undermine that overall resiliency.
It gets more interesting looking out into the second half of the year where the same market expectations are already pricing the possibility of a rate cut. Our interpretation is that if the CPI continues to surprise lower over the next few months, then the Fed could consider taking that step which would be consistent with the inflation outlook.
There is simply no reason to keep rates at 5% if it becomes clear the CPI expectations are converging toward the 2% target. That could play out regardless of how economic conditions are performing. We're willing to push back on a timetable for a rate cut if that means the economy continues to perform stronger than expected.
Where Does SPX Go Next?
Last year we published a note predicting stock market bears would end up with a " participation trophy ", suggesting the headwinds from 2022 would subside and stocks trend higher.
The reality here is that SPX is up from levels 9-10 months ago with the bears on the wrong side of the trade. This is the group that has been wrong about inflation, the trajectory of interest rates, Fed policy, economic conditions, labor market dynamics, and corporate earnings. The latest CPI pours additional cold water on several of those talking points. Anyone still looking for SPX to retest the lows of 2022 at $3500 will need to keep betting on an economic hard landing that has failed to materialize.
The way we see it playing out is that lingering pessimism in the market is slowly but surely being chipped away which translates into a slow-moving short squeeze. Bears essentially throwing in the towel on the apocalyptic scenarios and pivoting long can be a powerful catalyst for the next leg higher.
SPX is currently trading just under $4,200 which was the high of the year set back in February. A rally from here could put the August 2022 high of $4,300 back on the table which we believe would be set in motion even with strong momentum led by tech and growth stocks, among the most beaten-down names since 2021.
Getting into the Q1 earnings season, we believe the market is not giving companies enough credit for the cost-cutting and efficiency efforts that have made headlines in recent months. Ultimately, we see room for S&P 500 companies to outperform a low bar of expectations where margins also get a boost from lower inflation compared to the high benchmark in Q1 2022.
In terms of risks, the one real concern would be an environment where oil prices climb significantly higher, above $110/bbl levels that would be sufficient to add some new inflationary pressures. The ongoing Russia-Ukraine conflict remains a wild card where volatile conditions add to tail risks of sorts. Over the next few months, the CPI will be the key market monitoring point.
For further details see:
March CPI Delivered A Devastating Blow To Stock Market Doom-And-Gloomers