As we approach next week’s critical Consumer Price Index (CPI) release, a measure of inflation, markets have understandably been very choppy and very turbulent.
Speaking on Tuesday, Jerome Powell, the chairman of the Federal Open Markets Committee (FOMC), drummed in the fact that future rate hikes are necessary despite inflation trending down firmly. The market had previously priced in a terminal federal reserve funds rate of 4.9% - contradicting the FOMC’s guidance. But the market has finally yielded, with an expected terminal rate of 5.125%.
US markets initially rallied after JPow’s speech due to a dovish undertone or, at the very least, a lack of overt hawkishness. However, as the week progressed, this upwards move has retraced completely. The S&P500, a stock market index representing the performance of 500 large companies listed on stock exchanges in the United States, closed this week down 1.09%, a 3.13% fall from Tuesday’s high. This was the worst weekly close since December 16th. The Nasdaq 100 index, made up of the 100 most significant, most actively traded companies listed on the NASDAQ stock exchange, with a substantial weighting towards technology, closed the week down 2.13%, 4.66% from the week’s highs. Furthermore, the cryptocurrency market cap fell by 5.54%.
This sell-off reflects the delicateness of the US economy at the moment. It seems as though the economy currently teeters on a knife’s edge, balancing inflation fears and the damage that the deflationary monetary policy employed by the FOMC may do to growth. Current narratives are as follows:
1. Inflation returns to the 2% target hard and fast, and economic growth is significantly inhibited due to the high federal funds rate.
2. A goldilocks case – inflation returns to target, but growth and employment remain robust – the best-case scenario
3. Inflation is stickier than first expected and is entrenched. Therefore, the FOMC must continue raising rates or at least keep them at a restrictive level for longer than previously expected.
It seemed as though the most recent consensus view was the goldilocks scenario. Still, as time has passed, investors are seemingly second-guessing themselves and are now risk-off as we approach next week's CPI release. Admittedly, inflation seems likely to continue falling, and perhaps this sell-off was unwarranted. That said, inflation is notoriously hard to predict, and risk-reward is significantly skewed to the downside if next week’s CPI is higher than expected. For this reason, going risk-off seems sensible, though this may be a dip worth buying.
The markets are not all doom and gloom, though. For example, the FTSE100, an index similar to the S&P500 but comprised of only British companies, reached all-time highs. This seems pretty counterintuitive with a weak economy with a lot of uncertainty. However, this bullishness can mainly be attributed to the index's composition, with many miners and energy producers benefiting from higher prices from inflation. In addition, retail sales were strong in Q4 of 2022, with consumer demand remaining robust in the face of unprecedented inflation. This should be a reminder to all readers that the stock market does not always reflect the economy, and there is no doubt that many courageous short-sellers will be eyeing up UK stocks.
It has definitely been a tough week for traders and investors alike. Navigating economic uncertainty is a challenging vocation and is why the crème de la crème of macroeconomic forecasters are paid so well. The easiest option for traders is to be risk-off leading into the upcoming CPI release, where hopefully more light can be shed on the battle against inflation that the global economy has been fighting so fiercely.