The stock market’s start-of-year rally is poised to fizzle if a highly-anticipated U.S. inflation report on Tuesday dashes hopes for a quicker retreat in the cost of living in America, warned market analysts.
The January CPI reading from the Bureau of Labor Statistics, which tracks changes in the prices paid by consumers for goods and services, is expected to show a 6.2% rise from a year earlier, slowing from a 6.5% year-over-year rise seen in the previous month, according to a survey of economists by Dow Jones. The core price measure that strips out volatile food and fuel costs, is expected to rise 0.4% from December, or 5.5% year over year.
“Any core reading under 5.5% would likely be a short-term upward catalyst for stocks, and any reading above 5.5% would likely be viewed negatively by the markets over the very short-term,” said George Ball, chairman of Sanders Morris Harris.
See: CPI in the spotlight: Fed worried about sticky inflation
U.S. stocks finished sharply higher on Monday as investors assessed various signals for what the release of consumer price data might show. The Dow Jones Industrial Average ended 377 points higher, or 1.1%, to 34,246. The S&P 500 gained 1.1% and the Nasdaq Composite advanced 1.5%, after stocks posted their worst weekly declines in nearly two months.
The Federal Reserve Bank of Cleveland’s Inflation Nowcast is predicting a hotter-than-consensus CPI report. As of Monday, the Cleveland Fed’s model shows headline CPI to rise 0.65% month over month, or 6.5% on a yearly basis. For core CPI, the tracker estimates an 0.46% monthly increase and a 5.6% year over year advance.
“This model has had a mixed record of late, but is generally good at calling inflation trends,” said Nicholas Colas, co-founder at DataTrek Research. That means, if these nowcasts hold, it could terminate the stock market’s hope that inflation will melt away and fall back to the Fed’s 2% target any time soon.
See: Americans don’t expect inflation to fall this year
Meanwhile, a New York Federal Reserve consumer survey showed that expectations for inflation in 2023 were unchanged from 5% in December. The expected level of inflation three years from now stood at 2.7%, while inflation five years from now was projected to be 2.5%, the New York Fed said.
Stock market investors betting on a slower pace of rate hikes and a terminal rate near 5% cheered in the past two weeks after Fed Chair Jerome Powell acknowledged in his press conference following the FOMC decision that “the disinflationary process” is under way. Fed funds futures traders were pricing in a 76% probability that the fed-funds rate will reach 5-5.25% by May, according to the CME’s FedWatch tool.
A hotter-than-expected inflation reading on Tuesday could mark a turning point in the equity market’s expectations for inflation and interest rates, with “far-reaching implications,” said Michael J. Kramer, founder of Mott Capital Management.
Kramer thinks equity market have been in a “fantasy land” and that investors don’t appear to be “greatly concerned” about the coming CPI report, despite warnings from various parts of the markets.
“It seems that despite the expected increase in inflation from analysts and the warnings from the inflation swaps, options, and bond market about a potential trend of higher-than-previously-expected inflation in the future, the equity market is still oblivious,” said Kramer in a Sunday note.
“If CPI does come in hotter than expected, the equity market may find itself on the wrong side of the trend again, just as it has several times over the past 12 months.”
See: Stocks could suffer if U.S. inflation cools less rapidly as once thought, Deutsche Bank warns
Adding to potential volatility is the new weightings for the CPI calculation by the Bureau of Labor Statistics (BLS) released Friday.
The bureau changed its methodology from using consumption data during a two-year period to only one year to weight the CPI components. The BLS also updated spending weights used to calculate the CPI, which will be effective with January’s CPI report, and will result in a change in how much influence the various components will have on readings.
For example, the weighting for the shelter component will rise significantly to 34.4% from 32.9%, while the food weight will fall to 13.5% from 13.9%. Prices for used cars and trucks drop to 2.66% from 3.62%, according to Kramer.
“These changes in weighting could result in the CPI running hotter to start the year. For example, the inflation impulse from the owner’s equivalent rent is likely to continue to drive prices higher for some time, while the impact of declining used car prices will be less pronounced,” Kramer added.
See: Inflation data rocked the U.S. stock market in 2022: What investors need to know about Tuesday’s reading