Market Recovery Hinges On Rapid Fall In Inflation

Behind the markets’ better start this year is a broad bet that inflation will soon see a one-off decline.

Market-based indicators of inflation expectations project that the annual pace of rising prices will fall at about the same rate in the coming months as it did during the recession that followed the 2008 financial crisis — or when Fed Chair Paul Volcker used double-digit interest rates to break soaring inflation the late 1970s.

Hopes of a quick return to 2% inflation have encouraged bets that the Federal Reserve will pause and even reverse rate hikes this year. Rate hikes have hurt stocks and bonds in 2022, and a possible respite sent both higher in January. The rally has extended to some of the riskier assets that hit investors hardest over the past year, such as bitcoin and exchange-traded fund ARK Innovation, known for its focus on fast-growing tech companies.

Stock gains continued Monday as the S&P 500 rose 1.2%, led by advances in the technology sector. The tech-heavy Nasdaq Composite rose 2%, helping the recovery in stocks that suffered the most from last year’s rate hikes.

However, many Wall Street strategists warn that a painless end to elevated inflation will be elusive. Past bouts of inflation suggest that without a serious recession, it rarely falls as fast as markets are now predicting.

Economic data released last week showed signs of weakening consumer demand. More and more companies are laying off employees and reducing their profit estimates. Meanwhile, China’s economic reopening and a still tight labor market are adding to inflationary pressures that could lead to the Fed raising interest rates beyond those currently expected.

Avoiding a serious downturn while inflation falls quickly would be a “Goldilocks scenario,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “Pretty much everything should be right,” she said.

The markets are relatively stable at the moment. Despite oscillating over the past week, the S&P 500 is up 4.7% so far in 2023. Bonds have recovered. Both Treasury yields and derivatives markets reflect bets that CPI will rise about 2% by next January.

At the close on Monday, US Treasuries maturing in January 2024 were up around 4.7%, while inflation-linked government bonds maturing in the same month were down around 2.7%, according to Tradeweb. The difference between these numbers, called the breakeven inflation rate, suggests Treasury traders are betting that CPI will rise about 2% over the next 12 months.

Betting on contracts known as CPI swaps, another way of betting on future inflation rates, shows traders forecasting inflation of around 2.2% next year.

These numbers, if realized, would represent a historically rapid decline.

In June, annual CPI growth reached 9.1%, the highest since the early 1980s. If inflation falls to 2% by next January, that drop of about 7 percentage points would be compared to a similarly large drop that occurred between August 2008 and July 2009, when inflation fell from 5.6% to minus 2.1%. declined – in 2009 in the midst of an historic recession.

Before that, inflation hadn’t fallen that fast in 20 months since Mr. Volcker’s rate hike campaign in the early 1980s. The previous episode came as the economy normalized after the start of the Korean War.

Bob Michele, chief investment officer at JP Morgan Asset Management, warned that it is premature to expect inflation to continue its orderly decline through the end of the year. If it flares up again, he thinks the Fed could start raising rates again. Mr. Michele urges clients to avoid investing in distressed debt.

“There are many reasons for the Fed to stop and see what happens, but there are also many reasons it may need to go and hike further,” Mr. Michele said.

Monica Defend, head of asset manager Amundi’s research institute, is also concerned that the inflation consensus is overly optimistic. She expects the annual rate to stay below 4% over the next 12 months. Amundi advises caution when dealing with shares.

“We don’t think 2% is a viable target right now,” Ms Defend said.

In 2021, officials thought high inflation would be temporary. But a year later, it was still near a four-decade high. The WSJ’s Jon Hilsenrath explains three factors that have kept inflation higher than expected. Image: Jacob Reynolds

Since 2021, traders have consistently underestimated how fast prices have actually risen when making year-ahead inflation bets. Last year’s unexpected surge in inflation prompted the Fed to rein in rising prices, prompting rate hikes that helped the Nasdaq fall 33% in 2022.

However, the past three months have brought renewed optimism about a slowdown in inflation and an end to Fed hikes as early as March. December’s inflation rate of 6.5% was the lowest since late 2021. The Fed slowed the pace of its rate hikes this month and is expected to do so again on February 1st.

Rosy assumptions have helped assets that have suffered badly over the last year get off to a good start in 2023. The ARK Innovation ETF, a fund heavily invested in growing technology companies, is up more than 21% so far this year. The tech-heavy Nasdaq Composite, which has fallen more than other indices over the past year, is now overtaking it. Even Bitcoin has rallied after a disastrous 2022, up 39% against the dollar so far this year.

Quieter sectors were also boosted by expectations of a painless end to rising inflation. Homebuilder stocks have been up since mid-October even as Wall Street analysts have lowered their estimates for the industry’s future earnings, Schwab’s Ms Sonders has observed. In the past year, interest rate hikes hit the housing market hard, making mortgages more expensive.

Analysts who expect CPI inflation to cool off quickly this year point to a sharp fall in energy prices since the summer, as well as slowing food and some commodity price increases in recent months.

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But even if inflation falls as quickly as traders are now predicting, stocks could still struggle if the economy slides into recession as inflation falls.

A classic recession warning light has been blinking since this past summer. Short-term Treasury yields have been above those of longer-dated debt for months, a reversal of the norm and a signal that investors expect slower growth and rate cuts going forward.

That’s a strong reason to doubt the sustainability of the current stock rally, said Chris Verrone, head of technical and macroeconomic research at Strategas.

“We cannot blindly go long risky if the yield curve is not already indicating that we are on the other side,” said Mr. Verrone.

Write to Matt Grossman at [email protected]