US stock gains may become harder to achieve as the boost from the slowdown in inflation diminishes.

US stock gains may become harder to achieve as the boost from the slowdown in inflation diminishes.

The Potential Challenges Ahead for U.S. Stocks After the Inflation Relief Rally

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As inflation worries ease, U.S. stocks may need a fresh source of fuel to propel further gains this year, investors said. Data released on Thursday showed annual inflation, which had been running at 40-year highs a year ago, rose at a more moderate pace than expected in July, supporting the so-called “Goldilocks” narrative of disinflation and resilient growth that has won over bearish investors and boosted risk assets this year. But with many traders now betting the Federal Reserve is unlikely to raise interest rates again this year and fears of a U.S. recession receding, an improving inflationary picture may become less of a driver for stock prices going forward.

Indeed, stock moves have been more constrained on the CPI release dates in 2023 compared to last year when it was far less clear how far prices would rise and how aggressively the U.S. central bank would respond. Individual CPI reports have not had “a material and lasting impact” on markets for several months, indicating that the crisis period of inflation is over. The July CPI report, while encouraging, was not enough to take more Fed rate hikes decisively off the table. Traders of futures tied to the Fed’s policy rate saw less than a 10% chance the central bank will lift that rate from the current 5.25%-5.50% range at its Sept. 19-20 policy meeting, according to CME Group’s FedWatch Tool.

With the S&P 500 about 2.5% off the year-to-date high it hit last month, investors have cast a wary eye on the market’s stretched valuations. The index’s forward price-to-earnings ratio has risen to 19 times, well above its long-term average of 15.6 times. This reduces the attractiveness of stocks compared to bonds, with the benchmark 10-year US Treasury note yielding more than 4.00% and six-month Treasuries offering about 5.5%. The equity risk premium, which compares the attractiveness of stocks over risk-free government bonds, has been shrinking for most of 2023 and was around its lowest levels in well over a decade this week.

At the same time, stocks will have to contend with historically challenging calendar periods for equities. The month of August has delivered the third-lowest return for the S&P 500 since 1945, with September ranking as the lowest. This means that the coming months could bring additional headwinds for stocks. Stifel equity strategist Barry Bannister is among those who expect the U.S. stock market will be hard-pressed to climb from its current levels. In a note on Wednesday, he said the S&P 500 would likely “trade sideways” in the second half of the year and end 2023 at 4,400 points, about 1.5% below Wednesday’s closing level.

While the July CPI report is obviously positive for the markets, investors are reminded that the Federal Reserve is still engaged. The latest annual inflation rate of 3.2% remains above the Fed’s 2% target, suggesting that the central bank could still consider rate hikes. Another CPI report is due to be released before the Fed’s policy meeting in September, and the Fed’s annual economic policy gathering in Jackson Hole, Wyoming later this month could also influence markets.

In conclusion, the relief rally driven by the easing of inflation worries is facing potential challenges. As the inflationary picture improves, it may become less of a driver for stock prices. Additionally, stretched equity valuations and the attractiveness of high Treasury yields pose alternative options for investors. Moreover, the historically challenging calendar periods for equities in the months ahead could further restrain stock market performance. While the latest CPI report offers positive signs, the Federal Reserve’s engagement and the potential for future rate hikes should not be overlooked. Investors need to navigate these factors carefully as they evaluate the next steps for U.S. stocks moving forward.