An Overreaction?
Macro Perspectives
US Stocks closed sharply lower on Tuesday, with major averages retreating from record levels, after a hotter-than-expected inflation report.
The Dow Jones plunged by 523 points, posting its worst day since March 2023, the S&P 500 dropped by 1.3% and the Nasdaq fell nearly 1.8%.
Consumer prices also rose by 0.3% compared to the previous month, and the core rate increased to 0.4%, both exceeding expectations.
The robust inflation report prompted investors to reconsider their expectations for a rate cut by the Federal Reserve in March and May.
All key sectors were in the red with real estate and technology leading the losses as shares of major tech companies such as Microsoft (-2.1%), Amazon (-2.1%), and Alphabet (-1.6%) all fell.
The January inflation numbers came in a little higher; stocks were crushed, yields spiked and the dollar rallied.
How bad were the numbers? Core inflation (excluding food and energy) was less than a tenth of a percent above expectations. The 12-month change was 3.88%. That's the lowest level of this inflation cycle, and it was the tenth consecutive lower year-over-year core inflation reading - doesn't sound so bad.
What about the headline number? It was also a tenth of a percent above expectations on the monthly reading. The 12-month change fell from 3.35% to 3.09%. It didn't crack 3%, but it was the lowest reading of the past seven months.
Clearly this wasn't the positive surprise we thought we might get, but did it warrant a 4% selloff in small cap stocks, and a 14 basis point rise in the 10-year yield? Let's take a look at the two other times in the past three years that shared the features of 1) a down greater than 4% Russell 2000 and 2) at least a 14 basis point spike in the 10 year yield.
February 25, 2021. It was about inflation. The 10-year yield had risen from 1% to 1.6% in less than a month, and the move was quickening. The quickening was driven by the market's judgement that the additional $2 trillion fiscal package coming down the line from the new President and his aligned Congress was inflationary at best, and recklessly extravagant, at worst.
The $2.2 trillion Cares Act and the additional $900 billion in stimulus passed in December, before Trump's exit, had already driven a nearly full V-shaped economic recovery (by late January '21). The economy was projected by the CBO (Congressional Budget Office) to grow at a 3.7% annualised rate in 2021 (hotter than pre-pandemic growth), with an unemployment rate falling to 5.3% – about right at the average unemployment rate of the past 50 years.
The prospects of more, massive spending packages looked like an inflation bomb.
June 13 of 2022. It was a Monday meltdown, following a hot Friday inflation report. The Fed had just started tightening and was way behind the curve. Inflation was near 9%, the Fed Funds rate was below 1%. With a Fed meeting just days away, the market ratcheted up expectations for an aggressive 75 basis point hike. History suggested they needed to take rates a lot higher in order to stop fueling inflation, and start curbing it.
So, in both cases (Feb of 2021 and June of 2022) stocks fell sharply and yields spiked on significant inflation fears. It's fair to say the circumstances are quite different today. The Fed trajectory of inflation continues to go the right direction (lower) - the Fed is clearly looking in the direction of cutting rates, not raising rates.
With that in mind, was the selloff in stocks (and bonds) an overreaction? It looks that way. Let's take a look at the Nasdaq chart, which incorporates the dominant tech companies that are leading the next industrial revolution. It trades perfectly into a technical line of support — the trendline from the October lows.
The S&P futures traded into a similar line.
The trendline has significance. The October lows were driven by 1) Jerome Powell's intimation that the market had done the Fed's job of tightening, 2) the major reversal signal (outside day) that followed, in the bond market, 3) the huge Q3 earnings from the big tech oligarchy, and the reveal that they were all reorienting their businesses around generative AI.