By Carolina Mandl
NEW YORK (Reuters) – A long-awaited inflation report and elevated bond yields provide the latest test for a US equity rally that has delivered hefty gains this year.
The benchmark S&P 500 index is up 16.6% year-to-date, fueled by improving economic prospects, excitement over artificial intelligence developments and signs the Federal Reserve is about to end its market-destroying rate hikes in the U.S.
However, the near-term trajectory of equities may depend on whether next week’s inflation report shows consumer prices remain subdued. Investors are also closely monitoring government bond yields, which have shaken equity markets in recent days by rising to new yearly highs. The S&P 500 fell 2.27% this week, its biggest weekly drop since March 10.
“After a massive rally in stocks…any kind of pullback in terms of macro data is likely to be a reason for people to take profits,” said Jack Janasiewicz, portfolio strategist and portfolio manager at Natixis Investment Managers.
While consumer prices haven’t risen as fast recently, some investors worry that stubborn inflation could force the Fed to leave interest rates at current levels for longer than expected. The US will release consumer price data on August 10.
On Friday, US employment data showed that the economy maintained a moderate pace of job growth. Still, wages rose at a faster-than-expected annual clip of 4.4%. Many fear this is too high to be consistent with the Fed’s 2% inflation target.
Natixis’ Janasiewicz said a stronger-than-expected reading in consumer prices next week could lead to a fall of up to 5% in the S&P 500. He said such a fall would be “healthy” given the index’s large run this year .
Other investors have taken profits. Concerns about rising stock valuations prompted Aaron Chan, a managing partner at equity hedge fund Recurve Capital, to trim shares of companies such as Amazon.com, which is up 68% this year, and Norwegian Cruise Line, 47%.
According to Refinitiv Datastream, the S&P 500 trades at about 19.5 times 12-month expected earnings, much more expensive than its long-term average of about 15.6 times.
Rising global oil and food prices, which the Fed’s rate hikes have little impact on, may have more of an impact on inflation in the coming months, said Tim Murray, capital markets strategist at T. Rowe Price.
Brent crude prices were on track for their sixth consecutive week of increases, up about 17% over the period on signs of tightening global supply and rising demand.
“As long as the CPI holds steady to a downtrend, the market will fully accept it,” said Ann Miletti, Allspring’s chief of active equities. “If we see upticks, it really depends on where the upticks are and whether investors think they’re temporary in nature.”
Miletti is increasingly bullish in parts of the market that have underperformed, including small-cap stocks.
A stronger-than-expected inflation rate next week could also push government bond yields higher. Yields, which move inversely to bond prices, spiked this week following a downgrade of the US credit rating by Fitch and the prospect of government bond glut in the third quarter. The benchmark 10-year rate fell sharply after Friday’s jobs report, but remained above 4%, a level last seen in November 2022.
Rising yields on government bonds, considered one of the safest investments in the world because they are backed by the US government, could weaken the appeal of equities. Projected operating cash flows are also worth less in current dollars as interest rates rise.
“The shift in 10-year US Treasury yields above the 4% level is likely to be a headwind to further expansion of already high equity valuations,” Keith Lerner, co-chief investment officer at Truist Advisory Services, wrote this week.
There is still enough good news to keep the rally going. Earnings from Wall Street heavyweights Amazon and Google parent Alphabet have beat analyst expectations, though disappointing earnings from Apple caused the stock to plummet 4.8% on Friday.
More broadly, more than 79% of S&P 500 companies have beaten estimates for the second quarter so far, the highest success rate since the third quarter of 2021, data from Refinitiv I/B/E/S showed.
The past week also saw analysts from BofA Global Research and JPMorgan revise their forecasts for a US recession.
Still, some market participants believe investors will have to weather some turbulence in the near term.
“Our expectation is that the market will need some time to absorb the strong gains seen at the beginning of the year and enter a turbulent period,” Lerner said.
(Reporting by Carolina Mandl in New York; Additional reporting by Lewis Krauskopf; Editing by Ira Iosebashvili and David Gregorio)