Chief Investment Strategist
Summary: Yesterday's US inflation report was a surprise, pushing equity markets, especially Nasdaq, lower. This hotter-than-expected inflation pushed rate cut expectations further down the calendar. A March rate cut is off the table, with first cut either in May or June, and by December we might see four cuts. This is a drastic change from the seven cuts envisioned earlier this year. So what happened? Sticky core services inflation, underpinned by wage dynamics, is refusing to budge, and global manufacturing is showing signs of life. If the goods economy kicks in on top of this already stubborn inflation, things could get interesting. Should equity investors be worried? As long as inflation stays below 4%, recession matters more. If the economy stays afloat, sentiment should remain positive. However, recent sky-high valuations could become a problem if companies cannot deliver on earnings expectations.
Yesterday’s surprise upside in the US January inflation report showing CPI YoY of 3.1% vs est. 2.9% and core CPI YoY of 3.9% vs est. 3.7% pushed equities lower with Nasdaq 100 futures leading the declines down 1.6%. However, the leading technology index futures are already up 0.6% today reflecting that this inflation surprise is going to derail the equity rally for now. Before go deeper into what yesterday’s inflation report means for equities it worth observing the market change in pricing Fed rate cuts.
The table below shows that the current Fed effective rate of 5.33% with the 3-month SOFR Mar-24 futures closing at an estimated Fed funds rate of 5.28 yesterday reflecting that a March rate cut is completely priced out. The table also shows the estimated Fed fund rates at different date points in the future from those SOFR futures from one week ago and the difference. As we can see that compared to just one week ago, the market has removed an entire rate cut (25 bps.) by the July FOMC meeting. The current estimated Fed funds rate at the July meeting is now 39 bps. below the current effective rate suggesting the market is leaning towards two rate cuts by the July FOMC meeting but that it is close to 50/50. The table also show that the market is pricing four rate cuts (Dec-24 contract is estimating Fed funds rate 91 bps. below current effective rate) by the December FOMC meeting which is drastic change from early this year where is market was at seven rate cuts. So what has changed?
As we wrote in our What are the Fed’s possible considerations on rate cuts? Equity note back on 1 February there were several factors that were pointing towards that the Fed would hold back. Some of those were sticky core services inflation, loose financial conditions, trend growth in the US economy, and tighter labour market is the recent monthly observations. Yesterday’s inflation report showed exactly what we have been talking about that the wage dynamics are creating sticky core services inflation which yesterday gained 0.66% MoM and annualizing the 6-month average MoM figures hit 5.6% annualized. The upside case now on inflation is this. Base effects from lower energy prices are diminishing now and the global manufacturing sector is showing green shoots with PMI figures showing highest activity levels since August 2022. Imagine the goods economy kicks into gear again on top of the current sticky services inflation?
Should equity investors be worried about these inflation dynamics and that the path to the Fed’s estimated terminal Fed Funds Rate is now presumably going to be longer? As long as headline inflation remains below 4% we are not worried for equity returns from the inflation angle. A recession or not means much more for equity returns, so as long as we are not seeing clear signs that a recession is incoming we believe equity sentiment will remain positive. But as we have also discussed in several recent equity notes the high equity valuation levels are quite high and thus pose a risk should companies suddenly not be able to deliver on those high expectations.
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