On April 10, U.S. stocks experienced a significant downturn, with the Dow Jones Industrial Average shedding over 400 points, driven by a March inflation report that surpassed expectations. This outcome is anticipated to prompt a reassessment of Federal Reserve interest-rate cut projections. The market reaction also led to a surge in benchmark 10-year Treasury-note yields to their highest levels since early November. Despite these developments, there’s a crucial aspect of the inflation narrative that appears overlooked, potentially spelling trouble for stocks as the first-quarter earnings season approaches.
Headline inflation accelerated to an annual rate of 3.5% last month, as reported by the Commerce Department on April 10, while core price pressures, excluding food and energy costs, stood at 3.8%. Jamie Cox, managing partner for Harris Financial Group, noted that more than half of the increase in the Consumer Price Index (CPI) can be attributed to rising gas and rental prices, contributing to inflation exceeding 3%.
Although the S&P 500 has seen an 8.8% increase year-to-date, it faces a daunting challenge in defending these gains as it enters the first-quarter earnings season. Rate traders seem to agree, as CME Group’s FedWatch tool now places the odds of a June rate reduction at just 17%, down significantly from earlier projections.
The surge in inflation pressures coincides with a series of stronger-than-expected economic data releases for March. These include robust job growth and service-sector activity, suggesting healthy GDP growth for the first quarter. Skyler Weinand, chief investment officer at Regan Capital, emphasized the resilience of the U.S. economy and speculated that the Fed’s next move could involve a rate hike to control inflation.
All this follows one of the Fed’s most aggressive policy tightening phases in history, with the economy absorbing approximately five percentage points in rate hikes over the past two years alongside quantitative tightening. Despite this, the economy managed to grow by 3.4% in the final three months of last year, indicating its robust condition.
However, the recent surge in inflation is likely to compel the Fed to adjust its 2024 rate-cut forecasts, potentially impacting asset pricing across various sectors. As a result, financial market dynamics will apply a higher risk-free rate to asset pricing, potentially leading to lower real-time prices.
David Bahnsen, chief investment officer at Bahnsen Group, highlighted concerns about stretched valuations, suggesting that anything less than economic perfection or geopolitical stability could trigger substantial selloffs. Nevertheless, he emphasized that this market sensitivity should not be confused with directional weakness, given the market’s strength throughout the year.
The upcoming earnings season takes on renewed significance as investors closely monitor corporate performance and profit outlooks. John Lynch, chief investment officer for Comerica Wealth Management, emphasized the dependency of equity indexes on earnings delivery to substantiate higher valuations. Any profit disappointment may lead to a near-term correction in the S&P 500 Index.
Richard Saperstein, chief investment officer at Treasury Partners, noted that recent market gains have been driven by a combination of factors, including technological advancements, declining inflation, and expectations of Fed rate cuts. However, the resilience of inflation reduces the urgency for rate cuts, placing greater pressure on earnings to drive future market gains.
In summary, while the stock market has enjoyed significant gains fueled by optimism and expectations of Fed rate cuts, the recent surge in inflation underscores the importance of earnings in sustaining market momentum. With stock valuations near record highs, the burden is on earnings growth to drive further stock-market gains from current levels.