Inflation softens but stocks still fall, what next?

on Dec 16, 2022
  • Inflation came in below expectations in US, Europe and the UK this week
  • Stocks originally jumped on the news but peeled back after hawkish comments from central banks
  • Central banks have the 70's in their minds, when inflation was tamed three times, only to spike back worse

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It’s a funny game of cat and mouse they play, isn’t it?

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I wrote a piece a couple of months ago which opened with the question “what’s new?”. Stocks had surged to their best two-day return since 2020 following renewed hope that a Federal Reserve pivot could come sooner rather than later.

Well, Isaac Newton’s third law of motion states that for every action there is an equal and opposite reaction. It appears Mr Newton’s laws extend to the stock market, which has been yo-yoing back and forth on seemingly the same variable all year long.

This week has brought the opposite of that upward push, with the market peeling back after hawkish comments from central banks around the globe. But what does it all mean, and where does it leave us?

Inflation data beats expectations in US, UK and Europe

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This was a big week for the only thing that seems to matter for markets recently – inflation numbers.

The stock market initially soared on Tuesday after US inflation came in at 7.1%, down from 7.7% the previous month and beating expectations of 7.3%. It was the lowest reading since 2021, and the stock market wasted no time. It was off to the races, with the S&P 500 up 3% at the opening bell.

But Jerome Powell and the fun police, a.k.a. the Federal Reserve, decided to shut down the party. Powell said that the Fed would need “substantially more evidence” that inflation is softening, adding that “my view and my colleagues’ view is that this will take some time…let’s just understand we have a long way to go to get back to price stability”.

The market responded, dipping down. The S&P 500 has given up most of its gains, dipping back below $3900.

Europe follows the same path

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The ECB, which followed the Fed in hiking 50 bps, was even more hawkish. It committed to raising rates “significantly”, “at a steady pace” and to “sufficiently restrictive” levels, despite the easing inflation numbers.

The ECB rate is nonetheless only 2%, well south of the US rate of 4.25- 4.5%. The US thus remains well ahead of the UK and Europe, while the States are also in a better place economically. The energy crisis is choking Europe harder, as Russia continues its war on Ukraine, while a relentless dollar has been hurting the eurozone, too.

The dollar has, however, softened recently as inflation shows signs of being tamed.

What does this mean going forward?

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The labour market still remains resolute, however. The fact of the matter is that inflation is still so elevated that it seems hard to imagine a scenario where it is reined in without unemployment rising.

The Federal Reserve know this, and they know that inflation is far from over yet. The 1970s are likely prominent in their minds, when hiking rates did tame inflation, only for it to spike back up to higher levels after the foot was taken off the gas. In fact, this happened three times.

The message this time is clear: the Fed, and other central banks, are doing all they can to curtail inflation. Remember, expectations of inflation fuel further inflation. And until demand and spending are reined in – and some employment weakness is felt – inflation of this magnitude will persist.

The market saw the inflation numbers and concluded that this would be enough for Powell and the gang to soften their language a little, especially as recession fears mount. But Powell’s rhetoric Wednesday was clear to investors who feel that the Fed will abandon its fight against high prices as job losses mount and the economy careens towards recession. The market believed him, which is why prices have dipped.

It’s already only 27 days until the next CPI reading, when we ride the merry-go-round again.

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