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Market Extra: What does inflation mean for the stock market? Its supposed to be a positive—but investors are spooked now

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Inflation is supposed to be largely positive for the stock market, but signs of growing price pressures are rattling equities across the board this week, a potentially confusing scenario for investors.

The positive relationship probably hasn’t been abolished, but investors should make some allowance for heightened volatility around data as they wrestle with an economy roaring back from an unprecedented sudden stop caused by the COVID-19 pandemic, analysts said.

Indeed, investors have been whipsawed over the past several days, noted Jon Adams, senior investment strategist at BMO Global Asset Management, with $310 billion in assets under management, after a huge miss on the April jobs report on Friday followed by a big upside surprise on April inflation data on Wednesday.

“We expect a lot of volatility around economic data over the next few month,” he said.

See: The biggest ‘inflation scare’ in 40 years is coming — what stock-market investors need to know

Volatility was on display Wednesday, with the tech-heavy Nasdaq Composite
COMP,
-2.59%

tumbling 2.3%. Growth-oriented stocks sporting stretched valuations are seen as more vulnerable to inflationary pressures as they push up Treasury yields, but losses were widespread, also dragging down more cyclically sensitive sectors, including industrials and materials, that are expected to benefit from a pickup in inflation.

The Cboe Volatility Index
VIX,
+20.56%
,
a measure of expected S&P 500 volatility over the next 30 days, jumped 20% Wednesday to 26.40, hitting its highest reading since early March and above its long-term average short of 20.

The Dow Jones Industrial Average
DJIA,
-1.81%

was down over 500 points, or 1.6%, after suffering its biggest one-day drop since late February on Tuesday. The S&P 500
SPX,
-2.00%

dropped 1.8%.

The consumer-price index soared 0.8% to match the biggest monthly increase since 2009, the government said Wednesday. Economists polled by Dow Jones and The Wall Street Journal had forecast a milder 0.2% advance. The rate of inflation over the past year jumped to 4.2% from 2.6% in the prior month — the highest level since 2008.

Adams, in a phone interview, noted that rising inflation has typically been a positive for equities until the rate surpasses 3.5% to 4%, which is when worries about rising wages and their potential pressure on margins begins to kick in.

That said, the rise in the year-over-year rate in April was amplified by “base effects,” or comparisons with prices that had fallen sharply in 2020 as the pandemic brought the economy to a near halt.

The potential for wage pressures is a concern with companies reporting difficulty filling job openings and data showing a pickup in wages across industries, Adams said. Some of those factors may fade in coming weeks and months as children return to schools for in-person learning and extended unemployment benefits are rescinded or run out, analysts said.

While the April CPI data was a surprise, investors had certainly been anticipating a near-term surge in inflation due to base effects, supply-chain bottlenecks, and a surge in activity as rising vaccination rates and falling COVID-19 cases paved the way for a fuller economic reopening. And the Federal Reserve has remained consistent in arguing that, for those reasons, near-term inflation pressures will prove “transitory.”

Fed officials have vowed to keep rates on hold and its aggressive bond-buying program in place until inflation exceeds its 2% target on a sustained basis, making up for past periods of underperformance.

Fed Vice Chairman Richard Clarida on Wednesday said that if stronger demand relative to supply persisted and pushed inflation well beyond the 2% target, policy makers wouldn’t hesitate to act, But Clarida, who acknowledged his surprise at the April CPI rise, said he expects reopening-related price jumps to prove temporary, with inflation to return to its 2% long-run goal, or slightly above, in 2022 and 2023, in line with the Fed’s new policy framework.

But investors aren’t fully convinced. Combined with potential wage pressures, “higher inflation may be stickier than the Fed expects,” said David Kelly, chief global strategist at J.P. Morgan Asset Management, in a note.

“This puts more pressure on the Fed to begin to taper bond purchases within the next year and to raise short-term rates within the next two years,” he said. But that’s not across-the-board bad news for stocks.

“For investors, this points to higher interest rates in the months ahead which should be a positive for cyclical stocks and a challenge for long-duration bonds,” Kelly said.

Analysts this week’s broader market pullback may reflect an overdue round of profit-taking after the Dow and S&P 500 closed at records at the end of last week as investors pondered whether most of the good news around the economic reopening had been priced into the market.

Adams said it would make sense for investors to tilt portfolios toward small-cap equities and to employ a “modest tilt” toward value stocks, which look attractive within factors and across investing styles. Adams said that while he has a small preference for value, he isn’t ready to abandon growth and tech shares given his expectations that an expected rise in rates will be limited.

Looking ahead, investors should brace for more volatility around economic releases, but the wide misses on recent jobs and inflation data shows that investors will need to have “a healthy dose of humility in assessing slack in the labor market.”

“We’re in uncharted territory here in assessing the economic recovery” in the midst of an unprecedented economic reopening, he said. “We all need to be humble and able to change our minds given volatility around data.”

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