For the past two years, the specter of rampant inflation cast a long shadow over Wall Street and the broader U.S. economy. Each ‘hot’ inflation report triggered market volatility, sometimes leading to significant sell-offs. This pattern seemed unshakeable.
Yet, a recent shift suggests we may be witnessing a turning point. February’s Consumer Price Index (CPI) data revealed inflation that exceeded expectations. Surprisingly, stocks rallied in defiance of this typically negative catalyst. This marks a significant departure from the established trend, signaling a potential end to the era of inflation-dominated market reactions.
So, why the sudden optimism? Let’s dive into two compelling reasons emerging from the data:
1. Stabilizing Inflation: A Reason for Measured Optimism
Firstly, inflation seems to have settled around its long-term average of approximately 3%. While the past few months have seen CPI ‘stick’ in that range, causing concern among some analysts, a broader view reveals a less alarming picture.
Historically (since 1950), the U.S. inflation rate has averaged around 3.5%. Excluding the volatile 1970s, the average drops closer to 2.9%. Today, we’re at that long-term equilibrium point. Instead of needing to combat surging inflation, the task now becomes maintaining stability and preventing a significant resurgence.
This stabilization explains the market’s muted reaction to the latest CPI data. Investors recognize that while a small uptick or dip in CPI might occur, the broad picture shows the ‘inflation battle’ may be largely won. This is a bullish signal for stocks.
2. The CPI Outlook: Anticipating a Downward Trend
There’s strong reason to believe inflation could slide downward in the coming months, moving closer towards the Federal Reserve’s 2% target. This anticipated drop is tied to the lagging nature of the shelter CPI component, a significant contributor to overall inflation calculation.
Shelter CPI is based on actual paid rents, which often lag behind market asking rents due to fixed-term leases. Asking rents have been in decline for some time, and shelter CPI is now showing a similar trend (albeit at a delayed pace). This historical relationship suggests shelter CPI will continue its downward adjustment, bringing overall inflation down with it.
Importantly, housing costs are currently the primary factor keeping inflation above 2%. Other CPI components like food, apparel, energy, and furniture saw modest or even negative price changes in February. Excluding shelter, inflation sits below the long-term average.
This underscores the likelihood of inflation moving toward its target as shelter costs align more closely with market realities.
The Market’s Verdict: Focus on Earnings
The combination of stabilizing inflation and the potential for further easing seems to have significantly reduced investor anxiety. This explains the stock rally in the face of ‘hot’ CPI data. Wall Street is signaling that it’s time to shift focus away from a constant inflation watch, and instead prioritize company earnings.
This perspective is bolstered by remarkably strong earnings trends. Estimates for 2024, 2025, and 2026 are increasingly positive, indicating a healthy outlook for corporate performance, a key driver of stock prices.
Cautious Optimism and Strategic Considerations
With reduced inflation pressure and a bullish earnings picture, we could be transitioning into a new market era where earnings are the primary driver. This, of course, points to potential opportunities for investors, specifically in sectors demonstrating strong earnings growth.
