Inflation crosswinds in the next couple of months will likely lead to market turbulence in the near term, potentially providing a catalyst for the S&P 500 to retest either the top or bottom of its recent range. (UBS)

Overall, stocks have rallied during periods when disinflation was steady and not in doubt—including the first six weeks of the year, and the two months from late May to late July when the S&P 500 jumped 10%. By contrast, equities have come under pressure at times when overly strong growth data kindled fears of a renewed acceleration in inflation. This was the case from the end of July until about 10 days ago.

Based on the consensus forecasts, today’s release looks likely to contain some positive news. Economists are expecting the annual rate of inflation to slow to 3.3% in October, down from 3.7%. The monthly rate is forecast to slow to just 0.1% from 0.4%. This is consistent with our view that moderating inflation will allow the Federal Reserve to refrain from hiking rates further, putting cuts on the agenda around the middle of 2024.

But inflation data look set to provide less of a tailwind for markets in the coming months, in our view.

Progress in reducing underlying inflation looks likely to stall in the fourth quarter of 2024. After steady disinflation in the first half of 2023, forecasters don’t expect much further progress in the remainder of this year. Much, but certainly not all, of that is due to seasonal adjustments and specific factors, such as the annual medical care insurance cost adjustment. The result could be more than 0.3% month-over-month increases in the core consumer price index, which excludes volatile food and energy prices. That is above the roughly 0.2% needed to achieve the 2% inflation target.

So, while headline and core CPI should continue to fall, the monthly trend likely won’t look good for a few months. A renewed improvement may thus have to wait until the first quarter of 2024, when ongoing disinflation in the cost of shelter should cause progress to resume.

Surveys of consumer expectations of inflation have been mixed, keeping alive the threat of more entrenched price pressures. Expectations for long-run inflation have risen to the highest level since 2011, based on the University of Michigan’s November survey, with consumers seeing inflation at 3.2% over the next five years, up from 3% in October. That contrasted with a survey from the New York Fed, which pointed to slight decline in the median inflation expectation in the coming five years. While we don’t see indications that inflation pressures are likely to be sustained, and consumers have historically been poor at forecasting future inflation trends, Fed officials and investors would be reassured by a more consistent downward move.

The Fed is unlikely to be able to claim victory over inflation in the coming months. Recent signals from the central bank have been ambiguous, as policymakers keep their options open. On the one hand, the statement from the Fed’s 1 November meeting pointed to tightening monetary conditions—from higher bond yields as a drag on the economy that reduced the need for further hikes. However, since then, Chair Jerome Powell has said inflation is still “well above” where the Fed would like to see it, and that the Fed had a “long way to go” to hit its target sustainably. In addition, he has warned against inflation “head fakes”—the potential that the falling trend could go into reverse. If the Fed doesn’t have the luxury of looking through elevated inflation, then it’s hard for investors to do that.

So, inflation crosswinds in the next couple of months will likely lead to market turbulence in the near term, potentially providing a catalyst for the S&P 500 to retest either the top or bottom of its recent range. Despite this, our view remains that by next spring, inflation will have slowed to a comfortable level for both the Fed and investors. This supports our expectation for positive returns on both equities and quality fixed income over the coming six to 12 months, making it a good time to add to diversified balanced portfolios.

Main contributors - Solita Marcelli, Mark Haefele, Jason Draho, Christopher Swann, Jennifer Stahmer, Alison Parums, Wayne Gordon

Read the original report : Slowing inflation may become less of a tailwind for markets, 14 November 2023.