Wall Street cheers lower inflation, but a new risk has investors on edge

Taming inflation comes with a cost, and investors may start paying it sooner than they think.

Nov 17, 2023 - 23:30

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Wall Street cheers lower inflation, but a new risk has investors on edge

U.S. stocks have powered firmly higher from their late-October lows this week, helped in part by fading inflation prospects that have triggered a pullback in Treasury bond yields while erasing bets on a final Fed rate hike over the coming months.

Markets, in fact, are counting on the Fed to start cutting rates as early as next Spring, with the CME Group's FedWatch indicating a nearly 50% chance of a quarter point reduction at the Fed's May policy meeting, with more cuts to follow into the back-half of 2024.

Walmart (WMT) - Get Free Report CEO Doug McMillon added to the tepid inflation outlook, telling investors Thursday that the world's biggest retailer is ready for a period of deflation in the U.S. over the coming months, and plans to reduce grocery and other staples-items prices into the holiday season in order to offset that impact.

But taming inflation comes with a cost, and investors are starting to see that revealed in the first signs of real weakness in the job market.

The Labor Department reported Thursday that new applications for unemployment benefits jumped by 13,000 to 231,000 last week, the highest in nearly two years, and corporate layoffs are starting to accelerate.

Walmart's deflation warning might also portend some cost-cutting by others in the retail sector, and possibly beyond, in order to protect profit margins in advance of slowing revenue growth.

"Labor costs always are in the firing line when firms find themselves under pressure from weakening sales, or gross margin compression, or both," said Ian Shepherdson o Pantheon Macroeconomics.

"Any significant rise in layoffs will translate into slower payroll gains and rising unemployment, though we still think that a major rollover in the labor market is unlikely," he added.

Workers fulfill orders at an Amazon fulfillment center in Melville, New York.
Bloomberg/Getty Images

Inflation slayed, but growth concerns emerge

So, while Treasury bond yields are now firmly south of the multi-year peaks they reached last month as a result of the tamed inflation landscape, the extended moves lower may now reflect a broader concern for U.S. growth prospects as opposed to previous worries about elevated consumer price pressures.

"We do think there are signs of softness for the economy in the coming months, but not something that is extremely damaging or leads to recession or a hard landing," said BMO Wealth Management's chief investment officer Yung-Yu Ma. "A bit of softness played out in relation to softening inflation pressures or a labor market that remained healthy, but still didn't show too many signs of tightness."

That said, the Atlanta Fed's GDPNow forecasting tool suggests the economy is growing at a 2.2% clip, that's down from the searing 4.9% pace recorded over the three months ending in October but still a long way from suggesting the U.S. is facing near-term recession threats.

Big declines in global oil prices, which are down around 20% from their late summer peaks, are likely to deliver the lowest back-to-back CPI prints since the pandemic this month, according to Bank of America data, while providing a notable consumer spending tailwind in the form of lower U.S. gasoline prices.

Can stocks find end-of-year tailwind?

Chris Larkin, managing director for trading and investing at E*trade from Morgan Stanley, thinks it's still too early for the Fed to declare victory on inflation and notes that while rate cuts are still far off into the future, "more data like this will tamp down lingering concerns about an additional hike."

"The question now is whether this type of Fed-friendly data will continue to provide bullish momentum for the stock market," he added.

And there are undoubtedly a series of possible headwinds: earnings growth is likely to slow, at least on a sequential basis, to around 5.8% over the final three months of this year and a host of retailers from Walmart to Gap (GPS) - Get Free Report and Macy's (M) - Get Free Report are forecasting muted holidays sales action.

Investors aren't exactly banging down the doors to pile cash into stocks, either, with data from the Investment Company Institute noting money markets fund balances have risen to a record $5.73 trillion this year as investors find favor in risk-free Treasury assets over the riskier alternatives in major equity indices.

Vanguard's October Inflation Expectations Survey has also shown fading stock market sentiment, with expected stock market returns over the next twelve months pegged at 4.4%, down 1.1 percentage points from August.

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“Investor confidence followed the market downward in October,” said Xiao Xu, an analyst in Vanguard Investment Strategy Group. “The tide of investor sentiment appears to be turning away from summertime highs.”

That might be due to the fact that mega-cap tech stocks, which have powered much of the S&P 500's recent rally, and indeed year-to-date gains, aren't producing glittering near-term forecasts, either.

Apple's (AAPL) - Get Free Report holiday sales outlook was muted, adding to concern surrounding demand for its new iPhone 15 and slowing revenue growth in China, while Facebook owner Meta Platforms (META) - Get Free Report, continues to trim spending.

"The conversations on outlooks, demand, and the general macro [picture] have generally tilted negative," said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets. "Some companies have emphasized resiliency, stabilization, and normalization, but we are reading a lot more about uncertainty, challenging macro conditions, softening, and caution.”

"All of this leaves us skeptical about the 2024 consensus earnings forecast of $246 per share, a figure that implies year-over-year growth 11.4% above the 2023 consensus forecast," she added. "For this to pan out, we think the economy would need a clear path toward a soft landing, along with prospects for some above-trend GDP growth quarters."

James Demmert, chief investment officer at New York-based Main Street Research, however, has a different view.

"Investors have been far too negative over the past few weeks, and we believe this will only fuel the current rally," he argues. "Further short covering, along with institutional and retail investors being underweight stocks, will likely continue to drive the market higher into year-end."

"The average stock trades at only 14 times earnings and the economy is robust, which leaves lots of room for further market upside into year-end and in 2024," he added.