January 28, 2023

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Interest Rate and Inflation Tensions Kick Off a Chall…

A weekend of global inflation and rate insecurity ahead of key meetings and reports sends stock futures lower at the open.

5 min read

Photo by Getty Images

Key Takeaways

  • Stock Futures Sell Off as the Federal Reserve Could Face a Tougher Wednesday Rate Decision

  • S&P 500 Tests Bear Territory 

  • Pandemic Shutdown Concerns Rise Again in Asia

Shawn Cruz Director of Derivative Strategy, TD Ameritrade

(Monday Market Open) As inflation and interest rate worries spread over the weekend, stock futures tumbled before today’s open with the S&P 500 ever closer to bear territory. Bond yields jumped. With producer price data set for tomorrow, the Federal Reserve’s June interest rate announcement on Wednesday and a sizable triple witching date for contract expirations this Friday, investors can expect an active week.

Potential Market Movers

Investors reacted to Friday’s hotter-than-expected 1% rise in U.S. May inflation numbers with a broad pummeling of stock futures by Monday morning, as S&P 500 futures slid 2.4% near the market open.

If the S&P 500 (SPX) finishes down more than 1.3% at today’s close, that should make it official—SPX will be in a bear market, defined as a 20% drop from recent highs.

Before the market open, Nasdaq futures lost another 3% near the bell, while Dow Jones futures lost 1.8%. The CBOE Market Volatility Index (VIX) stood at 32 premarket.

The 10-year Treasury yield (TNX) was up to 3.26% and briefly inverted overnight, with the 2-year Treasury yield rising fractionally to 3.16% before the open. Seen by many as a recession indicator, it was the second inversion since April.

On Friday, the release of May Consumer Price Index (CPI) numbers—in addition to the lowest-ever monthly reading for the bellwether University of Michigan Consumer Sentiment survey—sparked aggressive selling during the session on fears the Federal Reserve may not be able to avoid a recession in its efforts to bring inflation under control. May’s CPI data revealed that inflation had jumped a whole 1% over the previous four weeks, exploding past analysts’ 0.7% forecasted increase and dwarfing April’s 0.3% increase.

On an annual basis, inflation grew at 8.6% year-over-year, well above the forecasted 8.3%. Annual core inflation came in at 6% instead of the projected 5.9%.

Global markets turned lower today with the Hang Seng (-3.39%), the Shanghai (-0.89%), and the Nikkei (-3.01%) all losing ground. Reports surfaced over the weekend that Shanghai may be going back into another pandemic lockdown.

European markets were down in midday trading with the CAC (-2.22%), the DAX (-2.18%), and the FTSE (-1.69%) all trading lower. The European Central Bank held rates steady last week but announced higher inflation and a plan to raise its key interest rate at its July meeting.

Earnings from Oracle (ORCL) are expected after the close.

Reviewing the Market Minutes

Setting the stage for this morning’s premarket declines, stocks sold off hard Friday after May’s worrisome inflation report. By the end of the session,  the S&P 500 (SPX) lost 2.91% toward its monthly lows near 3,900. If SPX closes below this level, it will be in a full-fledged bear market. Other major indexes didn’t fare much better. The Nasdaq Composite ($COMP) plunged 3.52% and the Dow Jones Industrial Average ($DJI) tumbled 2.73%.

With Friday’s announcement showing inflation at another 40-year high, consumers are feeling real stress as real earnings—earnings adjusted for inflation—fell 3% for the month. Significantly, AAA announced over the weekend that a gallon of regular gas now costs an average of $5 nationally.

Further evidence came from the University of Michigan’s monthly consumer sentiment survey later in the day. The bellwether report slid to an all-time low in June of 50.2, well under a consensus reading of 59 reported earlier by the Wall Street Journal.

Digging into the report, the Michigan numbers, subject to later revision, revealed that consumers are particularly concerned about inflation rising even further. A possible reset in consumer spending as a result could be a reason why the consumer staples sector stayed in the green most of the day. But even essential consumer products weren’t immune from the selling into Friday’s close and ended the day in the red too.

On Friday, the 10-year Treasury yield (TNX) spiked 12 basis points higher to 3.16%. The 2-year Treasury yield rose 23 basis points to 3.05%. The CME FedWatch Tool has forecast a high probability of a 50-basis point hike at next week’s Fed meeting as well as in July, September, and November. The rising yields pushed risk assets lower with the Russell 2000 (RUT) falling 2.73% and S&P 500 Pure Growth Index tumbling 3.95%.

CHART OF THE DAY: SUPER CYCLE. The S&P GSCI ($SPGSCI—candlesticks) tracks a cross section of commodities. The S&P 500 (SPX—pink) fell more than 50% the last time commodities rose to these levels. In the last two years, the commodity index has demonstrated some relative strength (green) against the S&P 500. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results. 

Three Things to Watch

Super Cycle: Friday’s CPI report had people talking about the commodity super cycle again. This refers to a period when commodity prices rise and tend to weigh on economic growth. The last commodity super cycle took place during the 2000s and caused the S&P 500 (SPX) to stay below the 1,500 level from 2000 to 2013. Another super cycle took place in the 70s when the S&P 500 traded sideways for nearly two decades. Of course, this doesn’t mean that the S&P 500 will do the same this time around.

Jeff Currie, the Global Head of Commodities Research for Goldman Sachs, has identified three factors that could feed a commodity super cycle, including decarbonization or the focus on green energy, deglobalization, and decades of easy money policies. Until these issues are addressed, it’s likely commodity prices will rise, and inflation will continue to be an obstacle.  

Real Yields: Some critics of the Fed have pointed to real yields as a reason why the Fed isn’t doing enough to address inflation. Real yields are the rate of return that savings or bonds provide when adjusted for inflation. For example, the 10-year Treasury yield (TNX) closed at 3.15% on Friday while inflation grew at 8.6%. So, the real yield difference is -5.45%.

During normal market conditions the real yield would be positive. In January of 2000, the 10-year yield was 6.5%. Inflation was growing at 2.7%. The real yield was 3.8%.

Some market analysts assert that the Fed must be more aggressive in raising rates to force yields higher and bring down the rate of inflation to make real yields positive again.

Falling Knives: Trying to buy stocks in a bear market is often called trying to catch falling knives. Market timing is very difficult because no one knows when the bottom will occur. However, many investors are recognizing that there are some bargains out there. One approach to investing in a falling market is dollar-cost averaging (DCA).

DCA is breaking up your investment dollars to purchase shares at regular intervals. This usually means you buy at different prices but the average price you enter is what you’re focused on. If the stock falls, you just got a better price. If the stock rises, some of your money is still growing with it.

There are several studies about DCA and lump-sum investing (investing your funds all at one time). The arguments about which is best is an old one. To sum them up quickly, DCA tends to outperform lump-sum investing during volatile markets, but most of the time, lump-sum investing tends to be the best over the long term.

Historically, stocks tend to outperform inflation in the long term and at a time where inflation is causing negative real returns, DCA offers an avenue for potential growth and access to dividends.

Notable Calendar Items

June 14: Producer Price Index (PPI)

June 15: Retail sales, FOMC Interest Rate Decision

June 16: Building permits, Housing starts, Philadelphia Fed Manufacturing Index and earnings from Adobe (ADBE), Kroger (KR)

June 21: Existing home sales

June 22: Earnings from KB Home (KBH) and H.B. Fuller (FUL) 

Good Trading,

Shawn Cruz

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