A highly anticipated inflation report and rising bond yields are posing a new challenge to the U.S. stock rally, which has seen significant gains this year. The S&P 500 index has risen by 16.6% year to date, driven by an improving economic outlook, advancements in artificial intelligence, and indications that the Federal Reserve is nearing the end of its interest rate hikes. However, the near-term direction of stocks may depend on whether the upcoming inflation report shows consumer prices remaining subdued. Additionally, investors are closely monitoring Treasury yields, which have recently reached new highs for the year, causing volatility in the equity markets. This week, the S&P 500 experienced its largest weekly decline since March 10, falling by 2.27%.
Jack Janasiewicz, lead portfolio strategist and portfolio manager at Natixis Investment Managers, believes that any blip in the macro data could lead to profit-taking by investors. While consumer prices have not been rising rapidly, some investors are concerned that persistent inflation may force the Federal Reserve to maintain current interest rate levels for a longer period than expected. The U.S. will release its consumer price data on August 10. On Friday, employment data showed moderate job growth in the economy, but wages grew at a faster-than-expected rate of 4.4%. This has raised concerns that the rate of wage growth is too high to align with the Federal Reserve’s 2% inflation target.
Janasiewicz suggests that a stronger-than-expected consumer price reading in the upcoming report could lead to a decline of up to 5% in the S&P 500. He believes that such a drop would be healthy given the significant gains the index has experienced this year. Other investors have already started taking profits, with concerns about rising stock valuations. Aaron Chan, a managing partner at equity hedge fund Recurve Capital, has reduced stakes in companies like Amazon.com and Norwegian Cruise Line due to their substantial gains this year.
The S&P 500 is currently trading at a price-to-earnings ratio of about 19.5 times forward 12-month earnings estimates, which is higher than its long-term average of approximately 15.6 times, according to Refinitiv Datastream. Tim Murray, a capital markets strategist at T. Rowe Price, believes that rising global prices for oil and food, which are not directly influenced by the Federal Reserve’s rate increases, may have a greater impact on inflation in the coming months.
Brent crude prices have been steadily increasing and are on track for their sixth consecutive week of gains, rising by approximately 17% during this period. Ann Miletti, Allspring’s head of active equity, states that as long as the consumer price index remains flat or decreases, the market will accept it. However, if there are any upticks in inflation, the market’s reaction will depend on the nature and perceived temporary nature of those upticks.
Miletti is becoming more optimistic about underperforming areas of the market, including small-cap stocks. A stronger-than-expected inflation number in the upcoming report could also lead to further increases in Treasury yields. This week, yields spiked following a downgrade of the U.S. credit rating by Fitch and the anticipation of a large supply of Treasury bonds in the third quarter. Although the benchmark 10-year yield fell after Friday’s jobs report, it remains above 4%, a level last seen in November 2022.
Rising Treasury yields, which are considered safe investments backed by the U.S. government, can reduce the attractiveness of stocks. Additionally, higher interest rates diminish the present value of projected company cash flows. Keith Lerner, co-chief investment officer at Truist Advisory Services, believes that the 10-year U.S. Treasury yield surpassing 4% will likely hinder further expansion in already high equity valuations.
Despite these challenges, there are still positive factors supporting the stock rally. Earnings from companies like Amazon and Alphabet have exceeded analysts’ expectations, although disappointing earnings from Apple caused a decline in its stock price. 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.
Analysts from BofA Global Research and JPMorgan have revised their forecasts for a U.S. recession. However, some market participants believe that investors may experience short-term turbulence. Keith Lerner expects the market to take time to digest the strong year-to-date gains and enter a period of volatility.
In conclusion, the U.S. stock rally faces a new test with the release of the inflation report and the rise in bond yields. The trajectory of stocks will depend on whether consumer prices remain subdued and the behavior of Treasury yields. Investors are cautious about potential profit-taking and the impact of persistent inflation on interest rates. Despite these challenges, positive earnings reports and a high beat rate for the second quarter provide some support for the stock market. However, analysts and market participants anticipate a period of choppiness and potential turbulence in the near future.
