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What’s next for equities after the collapse of the SVB and as a crucial measure of inflation looms

Investors are preparing for the release of a US consumer price index that may not show a significant drop in inflation, leaving few safe places to hide, while systemic risks may increase.

Just a few days after Silicon Valley Bank’s woes overshadowed Friday’s robust jobs report, Tuesday’s February consumer price index report will turn the focus back entirely to inflation.

Inflation traders are expecting an aggregate CPI of 6% yoy for February, following January’s 6.4% and December’s 6.5%. Even the narrower reading that cuts out volatile food and energy costs can be a problem. Researchers at Barclays said the core reading should be about 0.4% month over month and 5.5% year over year – little changed since the January data.

That is likely to create an environment where investors will have to rely on less traditional asset classes than ever before. When the US experienced stagflation in the 1970s, characterized by sluggish growth and sustained price increases, the main takeaway for investors was that high inflation across multiple countries was uniformly bad for both stocks and bonds, which had a harder time achieving positive real or inflation-adjusted returns, according to Deutsche Bank researchers Henry Allen and Jim Reid.

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Meanwhile, problems with regional banks further cloud the picture, increasing fears of systemic risk at a time when the Federal Reserve has become more determined to raise interest rates.

Many market participants are holding out hopes for a less aggressive rate hike by the Fed on March 22 and a policy path for the rest of the year. Meanwhile, the counter-argument is being made that the central bank won’t be discouraged by the sound of something breaking — an informal characterization of the damage done by the Fed’s full year of rate hikes.

Read: 10 banks that may be in trouble after the debacle of the SVB Financial Group

Silicon Valley Bank’s problems “complicate things by making it very difficult to understand financial conditions and by making a policy mistake more likely,” said Derek Tang, an economist with Monetary Policy Analytics in Washington. Yet Fed policymakers are unable to avoid a financial crisis when inflation is so high. They just don’t have that luxury.”

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To see: Silicon Valley Bank reminds that “things tend to break” when the Fed raises rates

While the impact of the past year’s rate hikes should already be hitting the U.S. economy, Tang said over the phone, “the other part of the story is that the rate hikes so far may not be enough to go against what’s stronger, more-sustained inflation.” If the U.S. does indeed enter an era of 1970s-style stagflation, cash and commodities, such as iron used in construction, would be among the most desirable assets for investors, he said.

What makes the prospect of another 6% CPI reading so unnerving is the new uncertainty it could bring to financial markets about where the Fed should go with interest rates. While policymakers prefer the PCE index and less volatile cores, the annual CPI rate matters because of its impact on household expectations. It has been consistently above 6% since October 2021, although lower than the peak of 9.1% last June.

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Theoretically, a new annual CPI reading of 6% would have the potential to increase the likelihood of a 50 basis point rate hike by the Fed on March 22. in 2023 and financing costs should remain high for one to two years.

According to Thomas Mathews, senior market economist at Capital Economics, the Fed wants to avoid a repeat of the “stop-go” monetary policy approach of the 1970s, when the central bank repeatedly alternated between tightening and easing financial conditions.

In the 1970s, the S&P 500 SPX,
produced an average nominal return of 6% annualized over the decade, even though the index was down 1% a year in real terms, according to Deutsche Bank. Treasuries “also suffered,” with nominal yields also wiped out by inflation, said researchers Allen and Reid, who described the decade as one of the worst on record for major assets.

An index produced by the bank, which looks at more than a dozen valuations of bonds and stocks in developed markets, reached its lowest level since 1800 in the late 1970s.

Source: Deutsche Bank

Read: ‘True asset destruction’: This chart from Deutsche Bank shows what could happen to assets in a repeat of the stagflation of the 1970s.

Over the past week, financial markets have flipped back and forth between estimating the prospects for higher interest rates – reinforced by two days of testimony from Federal Reserve Chairman Jerome Powell – and assessing the damage so far caused by central bank increases. The closure of Silicon Valley Bank has drawn attention to the toll of higher rates and placed a cloud over other banks.

On Friday, the policy-sensitive 2-year Treasury rate TMUBMUSD02Y,
experienced its biggest one-day drop since 2008, when investors flocked to the safety of sovereign debt. Traders increased the likelihood of a less aggressive rate hike by a quarter point later this month, which would push the Fed Funds rate target to between 4.75% and 5%, from current levels of 4.5% to 4.75%. All three major US stock indices DJIA,


ended lower and posted their worst week of 2023.

Tuesday’s February CPI report is perhaps the most important data for the week ahead. There are no important dates scheduled for Monday. On Tuesday, the NFIB Small Business Optimism Index is expected ahead of the CPI report.

Checking out: MarketWatch economic calendar

February’s producer price index is expected on Wednesday, along with data on retail sales, the New York Fed’s Empire State Manufacturing survey and US homebuilder confidence.

Thursday’s data releases consist of weekly jobless filings, home starts, building permits and the Philadelphia Fed’s manufacturing survey. Updates will arrive on Friday on industrial production, capacity utilization, the Conference Board’s US Leading Economic Index and the University of Michigan’s consumer-sentiment index.

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