Why next week’s inflation data means a pivotal week for U.S. stock market lies ahead

The June CPI reading from the Bureau of Labor Statistics, which tracks changes in the prices paid by consumers for goods and services, is expected to show a 3.1% rise from a year earlier, slowing from a 4% year-over-year advance seen in the previous month, according to a survey of economists by Dow Jones. The core price measure that strips out volatile food and fuel costs, is expected to rise 5.0% from a year earlier, down from 5.3% in May.  

Tony Roth, chief investment officer at Wilmington Trust, said his team expects to see disinflation continue in June, especially in the so-called super-core inflation, excluding energy, food and housing expenses, and which falls more slowly than the broader gauge.

“We expect to continue to see significant weakening across the board of inflation, and that should feed into this narrative that the Fed is going to be close to being done,” Roth told MarketWatch on Friday. “If it is the worst case scenario – two more hikes, that will also feed into that narrative that two more hikes should be able to accomplish their objective.”

However, it is hard for the stock market which is currently driven by “bullish sentiment” and “excessive cash balances” to continue the rally because “how can you get surprised on the upside when you’ve already priced in lots of good news,” said Irene Tunkel, chief strategist of U.S. equity strategy at BCA Research. 

“The stock market is more likely to go down from here than go up because once you are not getting the same level of positive surprises [in CPI data as you priced in], it is really easy for the market to come down,” Tunkel said. 

Overly bullish sentiment, extended valuations for technology companies, and improving economic expectations are fertile ground for disappointment in the stock market, especially when monetary policy is restrictive, according to Tunkel. “It’s just too early to celebrate victory,” she said. 

See: Here’s what stock-market investors — and probably the Fed — don’t like about the June jobs report

The U.S. stock market has swung from “hard landing” fears in the first half of 2023 to the “soft landing” hopes in the second half after the Fed decided to leave its benchmark interest rates unchanged at 5% to 5.25% in June. However, Fed Chair Jerome Powell warned that policy makers still expect more interest-rate increases this year to combat inflation, with some of them forecasting two more quarter-point hikes in the second half of 2023. 

Investors had to weigh up a mixed bag of economic data this week. U.S. stocks suffered broad losses on Thursday after data showed the private sector created nearly half a million new jobs in June, sending Treasury yields

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higher and spurring fears of further Fed interest rate hikes as the labor market still remains too tight for the central bank to relax its monetary tightening. 

However, one day later, a still-strong but weaker-than-expected June nonfarm payrolls report has taken some steam out of what had been a stunningly resilient labor market, leaving investors divided over whether the results are strong enough to force policymakers to raise rates further than expected and risk driving the economy into recession.

Fed-funds futures traders priced in an over 92% probability the Fed will lift the benchmark interest rates by 25 basis points to a range of 5.25% to 5.5% later this month, according to the CME FedWatch Tool. Meanwhile, expectations for another quarter percentage point rise in either September or November faded somewhat on Friday, but remained above 25%. 

David Lefkowitz, head of equities Americas at UBS Global Wealth Management, said the “overall tone” of the jobs data is that the U.S. economy continues to remain resilient. “A big beat on the ADP and a little bit of a miss on the government job report — the larger picture here is that the U.S. economy remains more resilient than the markets had been expecting a few months ago,” he told MarketWatch in a phone interview on Friday. 

However, Roth of Wilmington Trust thinks Friday’s report shows a “major inflection in the labor market” that there is no reason to think that the Fed still needs to keep rates at higher levels for so long, but it is “very orthogonal” to the Fed’s tightening path in the second half, which is more interest-rate hikes.

“The way I would describe it now is that any further hikes are ‘insurance hikes’” for the Fed to complete its job against inflation, said Roth. 

See: Markets caught in ‘self-defeating feedback loop’ with Fed on inflation, hedge-fund trader says

Lefkowitz pointed out that it’s important for investors to take the interest-rate moves in context in terms of “what else is going on” in the economy. The rate moves so far in 2023 are mainly driven by a “better economic growth outlook” than inflationary pressures, he said. 2023 also provides a better environment for corporate profit growth which may significantly improve compared to the second half of 2022, with companies’ forward estimates rising over the last three months, according to Lefkowitz.

However, Tunkel at BCA Research said it is the “conundrum” between economic growth and inflation that makes the current economic picture muddled. 

“The economy will have a very long runway from very strong growth, and because rates are not restrictive enough, that runway keeps getting longer,” Tunkel said via phone. “That is the conundrum because if we do have strong growth, inflation is unlikely to come down because growth and inflation are attached at the hip – they move in lockstep.” 

U.S. stocks finished the week lower with the Dow Jones Industrial Average

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seeing its largest weekly decline since March. For the week, the Dow dropped nearly 2%, the S&P 500

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fell 1.2% and the Nasdaq Composite

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declined 0.9%, according to Dow Jones Market Data.