Recent market movements
S&P 500, after touching record highs over 5.000, has been hit by a hot CPI reading that showed inflation remains stickier than expected.
The risk-off momentum pushed the S&P 500 down 1.4% on Tuesday, its worst CPI—day performance since September 2022. The Nasdaq 100 Index fell 1.6%, while the stocks with the highest short interest dropped 5.5% in the biggest loss in almost a year. Roughly 91% of the stocks on the New York Stock Exchange traded lower, the most since March 2023.
Chris Zaccarelli, Chief Investment Officer at Independent Advisor Alliance LLC:
“The data put in doubt investors’ optimism that the central bank’s interest-rate cuts are basically a done deal. It reinforced the idea that interest-rate cuts are not coming any time soon. And if that’s the case, all of a sudden the stock-market rally is looking stretched”.
But the today, US equity futures and Treasuries signalled a partial rebound, with contracts on the S&P 500 ticking higher after the worst inflation-day drop for the index since September 2022. Benchmark Treasury yields retraced some of the previous day’s surge, but held above 4.2%, as traders trimmed bets for an early Fed rate cut. Europe’s Stoxx 600 index was steady as investors assessed the latest earnings news.
Despite the setback, investors riding bets on an eventual Fed pivot to easier policy aren’t hitting the sell button. BlackRock portfolio manager Russ Koesterich sees the setback as temporary, with potential for further upside to US stocks of 6-8% this year and possibly four rate cuts still in the offing.
“Despite yesterday’s action in the stock market it’s probably going to to be a decent year for US equities. There’s reason to stay long equities. I don’t think the narrative changes. We still think that the Fed will begin cutting late this spring or in the summer. We still think three, maybe four, cuts are likely”.
What if Fed doesn’t cut?
This scenario is the most feared by traders. Currently, the sentiment is that the process of rate cuts will be slower than expected, and will probably even start later. They will be forced to adapt to Fed’s forecasts.
The timing and number of cuts predicted by the market was ultra-optimistic and now the probability of a cut in March went to zero, while the probability of a rate cut in May fell to 32% vs. 64% before CPI. Market was pricing 175bps cuts in 2024, but now is only 90bps. What about yields? The 2-years notes rose to 4.66%, the 5-years to 4.32%, and the yield on the 10-year jumped above 4.20% to 4.33%.
Pre CPI, as shown by JPMorgan’s survey covering week up to Feb. 12, client short positions dropped an additional 3ppts to the fewest since August 2012. The move was fuelled by rising uncertainty on yield direction, with neutral positions rising to the highest since January last year. After CPI, these positions have been opened again.
Looking at options, the premium paid to hedge a selloff in long-bond futures extended sharply, reaching the most expensive since November last year. Some of the long-bond put premium may be starting to reflect potential for a cheapest-to-deliver shift in the long-bond futures contract and hedging around such a scenario. Investors are feeling a downside risk.
What could come next
The rally that started in October was due to generally good earnings and a growth in multiples expansion. And what drove the rise in the forward 12-month P/E ratio? On October 27, the forward 12-month P/E ratio was 17.0, as the price of the index hit its lowest value since May 24 at 4117.37. Since October 27, the price of the S&P 500 has increased by 21.4%, while the forward 12-month EPS estimate has increased by 2.0%. Thus, the increase in the “P” has been the main driver of the increase in the P/E ratio over the past few months. (FactSet)
This growth, driven by rate cuts expectations, will probably revert.
On the other hand, the Fed targets the PCE deflator (esp the core), not the CPI. There are no dot-plots for the rent-laden CPI. And as pointed out by TS Lombard, CPI delivers a different message than PCE.
"There is no return to 2% inflation without a recession of some sort. The January CPI data, and more critically the acceleration of service inflation since the economy skirted recession last spring, tell us just that many believe the Fed remains dangerously tight, risking recession down the road, using PCE inflation data".
The inflation trend is still on a downward path, but it won’t be a straight line. So it is important to keep an eye on the next reading.