The market is proving to be not so invincible after all and inflation is still its kryptonite. If the headline inflation rate dropped back to 2.9%, as was expected, we may have very well seen risk assets rally further on the “strong economy with disinflation” narrative. Instead, the year-over-year inflation rate only ticked down to 3.1% with the inflation and core inflation rising 0.3% and 0.4% month-over-month, respectively. It’s the latter number that’s especially discouraging to me. Core had already been running at a 3-4% short-term annualized rate before January’s reading and this report is indicating that inflation may actually be re-accelerating, not decelerating. Look, we know that we’re still at the end of the window for the lagged effects of the Fed’s rate hiking cycle to work themselves into the system. We’re still likely to see some level of tightening over the next few months, but given that GDP growth is still running at over 3% and monthly inflation in the U.S. has actually been picking up again over the past few months, I don’t think we can write off the possibility that the Fed could have another hike left in them. Granted, I think it’s a low probability, but I don’t think we can discount it altogether.
In my opinion, the U.S. equity market is still a small-cap story. The fact that the major averages are being driven higher by a handful of mega-cap tech stocks is a comfortable one for investors, but it’s also not terribly telling. The fact that investors are fleeing only to a half dozen stocks may in and of itself be a flight to safety trade if they don’t see attractive opportunities almost anywhere else. Small-caps and virtually every other non-tech sector within the S&P 500 would seemingly confirm that idea. Small-caps are really where the meat of the U.S. economy is at. They’re the ones trying to grow. They’re the most leveraged. They’re the most vulnerable to debt and refinancing risk. The longer that interest rates remain elevated (and it would seem to be longer than the market expects given what Powell has already said and this week’s inflation numbers), we’re going to start seeing these small companies start dropping like flies. The further out that rate cuts go, the likelier it is we see a major credit event around excessive debt and corporate bankruptcies. If you want to end inflation, this would be the quickest way to do it.
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