The US stock rally faces a test as the latest inflation report and elevated bond yields raise concerns about the future economic outlook. Despite the benchmark S&P 500 index recording impressive gains of 16.6% year-to-date, driven by positive economic indicators and advancements in artificial intelligence, the upcoming inflation report and Treasury yields are key factors influencing market sentiment. The S&P 500 experienced its largest weekly decline since March 10, falling 2.27% this week, as investors eagerly await the inflation report to determine whether consumer prices remain subdued. Additionally, the path of Treasury yields, which hit year highs and caused volatility in equity markets, is being carefully monitored.
Jack Janasiewicz, lead portfolio strategist and portfolio manager at Natixis Investment Managers, suggests that any negative macro data could potentially result in profit-taking after the significant surge in equities. While consumer prices have not risen rapidly recently, some investors are concerned that persistent inflation may cause the Federal Reserve to hold interest rates at current levels for longer than expected. The US is set to release consumer price data on August 10, which could impact the stock market depending on the reading.
The US employment data released on Friday showed moderate job growth, although wages rose higher than expected at an annual rate of 4.4%. This has raised worries that it may surpass the Federal Reserve’s target of 2% inflation. Janasiewicz warns that a stronger-than-anticipated consumer price report next week could potentially lead to a 5% decline in the S&P 500, which he considers a healthy correction given the index’s significant gains this year.
Concerns about elevated stock valuations have prompted some investors to take profits. Aaron Chan, managing partner at equity hedge fund Recurve Capital, has reduced stakes in companies such as Amazon.com and Norwegian Cruise Line due to rising stock valuations. The S&P 500 is currently trading at approximately 19.5 times forward 12-month earnings estimates, significantly higher than its long-term average of 15.6 times, according to Refinitiv Datastream.
Tim Murray, a capital markets strategist at T Rowe Price, suggests that rising global prices for oil and food, which are not heavily influenced by the Federal Reserve’s rate increases, may have a greater impact on inflation in the upcoming months. Brent crude prices have experienced six consecutive weeks of gains, increasing by approximately 17% due to tightening global supply and rising demand.
Ann Miletti, head of active equity at Allspring, believes that as long as consumer price index (CPI) remains flat or trending down, the market will accept it. However, if there are significant upticks in CPI, investors may question whether they are temporary or have lasting effects.
If next week’s inflation report indicates stronger-than-expected inflation, it could lead to further increases in Treasury yields. The recent downgrade of the US credit rating by Fitch and the anticipation of a flood of Treasury supply in the third quarter has caused yields to rise. Although the benchmark 10-year yield dropped after Friday’s jobs report, it still remains above 4%, a level last seen in November 2022.
Rising Treasury yields, which are considered safe investments, could diminish the allure of stocks. Additionally, higher interest rates reduce the current value of projected company cash flows. Keith Lerner, co-chief investment officer at Truist Advisory Services, suggests that the move in the 10-year US Treasury yield above 4% could act as a headwind to further expansion in already high equity valuations.
Despite the potential challenges, there is positive news supporting the ongoing rally. Earnings from major Wall Street companies, such as Amazon and Google-parent Alphabet, have exceeded analysts’ expectations. However, disappointing earnings from Apple caused a 4.8% drop in its stock price on Friday. Overall, more than 79% of S&P 500 companies have beaten estimates for the second quarter, the highest beat rate since the third quarter of 2021.
While some analysts have revised their forecasts for a US recession, others believe that investors may experience short-term turbulence. Keith Lerner expects the market to enter a choppy period as it digests the year-to-date gains.
In conclusion, the US stock rally is facing a critical test as the upcoming inflation report and elevated bond yields influence market sentiment. Investors are eagerly awaiting the report to gauge whether consumer prices remain subdued, while closely monitoring Treasury yields. A stronger-than-expected inflation reading could potentially trigger a decline in the S&P 500, which some experts consider a healthy correction. Rising stock valuations have prompted profit-taking, and investors are concerned about the impact of elevated Treasury yields on equity markets. Despite these challenges, positive earnings results and an overall beat rate exceeding expectations provide some support for the ongoing rally. Investors should be prepared for potential turbulence as the market digests its significant year-to-date gains.