Stocks stage a reversal despite inflation measures registering 40-year highs

October 13, 2022 | Market news

Key takeaways

  • A 40-year high in core consumer prices continues to keep pressure on the Federal Reserve to aggressively raise interest rates to slow the economy and combat inflation.
  • Despite higher-than-anticipated inflation, equity prices staged a strong rally during today’s trading session, recovering sharply from earlier losses.
  • While we are encouraged by today’s recovery across riskier asset classes, we think it’s premature to declare that lower prices are behind us, and we anticipate continued volatility as a news-heavy quarter concludes.

Capital markets hoped that Thursday’s Consumer Price Index data release, which is a monthly figure tracking prices within cities including food, shelter, apparel, medical services, energy and other costs, would slow from last month. Contrary to that hope, the Bureau of Labor Statistics’ September inflation report showed that, like August, sticky price pressures across shelter and other services continue to offset gasoline price declines. While the headline inflation gauge slowed to an 8.2% increase relative to a year ago, core inflation (which does not include volatile food and energy prices) rose to a new 40-year high. That sequential increase ran counter to those hoping inflation may abate and reflected inflation’s persistence across the economy, a continuation of prior trends.

At the equity market open today, U.S. stocks, as represented by the S&P 500, fell to new intra-year lows while bond prices also declined and yields, which move in the opposite direction of price, rose. Bond market prices reflected expectations that the Federal Reserve (Fed) would be even more aggressive with its rate-hiking campaign intended to thwart inflation. With those concerns, the 10-year Treasury bond fell in price and its corresponded yield exceeded 4% for the first time since 2008. Further, two-year Treasury yields surged to 4.5%, a 15-year high.

However, the equity and bond market selloffs staged a dramatic reversal, particularly in the equity market. The Energy, Financial and Materials sectors, traditionally economically sensitive, led the S&P 500 higher along with the beleaguered Technology sector, which had been hampered by consumer demand trends and supply issues, particularly within semiconductors. Volume was strong throughout the day, leading many to wonder if today’s reversal — despite continued inflationary pressures — means that perhaps the more than 26% decline in the S&P 500 and double-digit losses in major bond indices meant that we had reached oversold levels. While we are encouraged by today’s strength within traditionally riskier asset classes, we think it is premature to declare that lower prices are behind us.

Previously, we have shared our perspective on asset classes relative to a framework we call the “two repricings,” which we believe continues to remain firmly in play. Fed interest rate hikes have catalyzed the first repricing, which is when short-term interest rates represented by two-year Treasury yields rose from 0.7% at the beginning of the year to today’s 4.5% rate; all other asset classes have repriced to reflect the increased competition from safer assets’ higher yields. In other words, investors demand higher compensation (via paying lower prices) for taking on greater risks relative to the 4.5% yield they could receive from two-year Treasuries.

The second repricing relates to the potential for higher interest rates to impact real economic activity via lower consumer spending and business investment as borrowing costs increase and confidence in the near-term economic outlook worsens. Consumer spending and corporate profit growth have remained resilient to date due to consumers’ ability to draw down savings accumulated during the pandemic. However, analysts’ estimates for S&P 500 earnings for the rest of 2022 and 2023 have started to decline, anticipating that higher rates and persistently elevated inflation may cause consumer and business activity to eventually slow.

While consumer and business activity have yet to reflect this second repricing scenario, Thursday’s inflation report continues to pressure the Fed to raise interest rates aggressively to bring inflation back within its price stability mandate. As the Fed further tightens interest rates into a slowing economy, the risks of a material slowdown in consumer and business spending increase, leading to heightened capital market price volatility.

Friday marks the unofficial kickoff to third quarter corporate earnings reporting season, and company guidance and spending plans will be key focal areas helping shape our forward views. In the interim, we continue to have a cautious near-term outlook as the Fed responds aggressively to inflationary challenges, and we anticipate elevated capital market volatility (both bear market rallies and declines) following a sharply negative September.

The fourth quarter will be a news-heavy close to the year, with China’s Party Congress, U.S. mid-term elections, two Fed meetings, forthcoming economic releases and corporate earnings reports providing numerous data points and policy events for investors to digest. We encourage clients to focus on their unique circumstances and use every opportunity to engage with their wealth management professional to help ensure their investments match their financial plan. Institutional clients should reaffirm that their investment policy statement reflects their organizational or asset pool objectives.

We appreciate your trust and will continue to share our thoughts and perspectives as events unfold and capital markets respond. Please do not hesitate to reach out for specific questions and how we can help weather these fluctuations.

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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.

Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is one of the most frequently used statistics for identifying periods of inflation or deflation.

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