US stock rally braces for the gauntlet of key inflation data and Fed's decision on rates

A double dose of potentially market-moving US events next week could set the tone for asset prices in the rest of 2022 and beyond, as investors brace for a key inflation report followed by the last Federal Reserve meeting of the year.

The S&P 500’s latest rebound stalled in the past week, as stronger-than-expected economic data fuelled concerns that the Fed will need to keep interest rates higher for longer in its bid to crush inflation, potentially bringing on a recession. The index has bounced about 10 per cent from its October lows but remains down more than 17 per cent on the year.

Equities’ trajectory in the near future may depend on whether Tuesday’s consumer price index report shows inflation is responding to the most aggressive Fed hiking cycle since the 1980s. Hotter-than-expected data could bolster fears of more Fed hawkishness, pressuring stocks.

“If the CPI comes in north of expectations or even doesn’t decline at all, that is not going to be market-positive," said Tom Hainlin, national investment strategist at US Bank Wealth Management.

CPI reports have been catalysts for outsized swings in markets this year, with the S&P 500 moving an average of around 3 per cent in either direction over the past six CPI releases, compared with an average daily move of about 1.2 per cent over the same period.

That includes a September 13 inflation release that sparked a 4.3 per cent sell-off and a November 10 report showing softer-than-expected inflation that fuelled a 5.5 per cent rise and helped stocks extend their latest rally. A second helping of benign data could bolster the case for a peak in inflation and buoy equities further.

“Typically around the CPI reports it has been pretty volatile this year, and I don’t see a reason to think it still won’t be that way when we get the data next week,” said David Lefkowitz, head of US equities at UBS Global Wealth Management.

Meanwhile, investors are factoring in a half-percentage-point rate hike from the Fed next week, a step down from its recent series of three-quarter-point increases. With Wednesday's rate action largely seen as a foregone conclusion, Wall Street will be focused on the central bank’s projections for how high rates will ultimately rise.

Also key will be Fed chairman Jerome Powell’s views on inflation and the possibility that the economy can slip into recession next year — an idea that has filtered into asset prices and dominated investor thinking lately.

One closely-watched indicator can be seen in the US government bond market, where the Treasury yield curve recently inverted to its steepest level in at least 20 years, magnifying a signal that has preceded past economic downturns.

Mr Hainlin said he is concerned that pressure from higher rates on consumer and business spending has yet to be factored into investors' earnings expectations. The firm is slightly overweight fixed income and favours shares in sectors viewed as havens during rough economic times, such as utilities and healthcare.

Some believe a hefty amount of cash on the sidelines and seasonal factors could help invigorate the stock rebound if inflation is weaker than expected or investors like what the Fed has to say.

Investors that have whittled down equity positions and beefed up cash reserves have shown a tendency to jump aboard stock rallies in recent months, helping amplify upside moves in equities.

A Deutsche Bank report published on December 4 showed that equity positioning remained lower than it had been for about 86 per cent of the time since January 2010, although it has crept higher in recent weeks. Cash levels among fund managers surveyed by Bank of America Global Research stood near multi-decade highs last month.

At the same time, the S&P 500, which is down 3.6 per cent so far this month, has risen an average of 1.5 per cent in December since 1950, the third-best performance of any month, according to the Stock Trader's Almanac.

“People, ourselves included, would expect the seasonals to take us into year-end, absent a huge surprise on the CPI and the Fed,” said Walter Todd, chief investment officer at Greenwood Capital.

Others, however, think the recent rally in stocks is already all but over. Morgan Stanley strategists earlier this week warned clients of risks to corporate earnings and urged investors to stay “defensively oriented” in areas such as healthcare and utility stocks.

“We recommend taking profits before the Bear returns in earnest,” they wrote.