Investors renew focus on Fed following signs that inflation has peaked

New York

DATA on Wednesday hinted that US inflation may have peaked, reassuring investors that the Federal Reserve will not feel obligated to hasten plans to rein in emergency-level support of the economy, but they remained worried that rising prices could continue to weigh on everything from bond prices to corporate margins.

US consumer price increases slowed in July even as they remained at a 13-year high on a yearly basis. The S&P 500 and the Dow Jones Industrial Average closed at record levels, while US Treasury yields fell across most maturities.

Some investors said the data bolstered the Fed's assertion that jumps in inflation will be relatively fleeting, partly reflecting supply chain bottlenecks that will ease with time.

But they added that inflation remains elevated, which can sap profit margins and erode the value of bonds.

Other concerns: Corporate earnings growth appeared to be hitting a peak; rising coronavirus cases could threaten the economy; and stocks are generally trading at historically high valuations.

The inflation data would help the Fed feel a "a little bit more confident that they can let inflation run a little bit hotter in the near term without having to worry about overshooting", said Gennadiy Goldberg, senior US rate strategist at TD Securities.

"Markets are reacting with a bit of relief, which I think makes a lot of sense," he added.

The Fed has dropped interest rates to rock-bottom levels and is currently making US$120 billion in monthly bond purchases, as it has aimed to spur spending and borrowing. The question of when and at what pace it expects to taper those purchases looms large over markets.

"The concern has been how soon and how quickly will the Fed begin to taper its bond purchases, and this lends some credence to the argument that the inflation pressures we are seeing are transitory," Jim Baird, chief investment officer at Plante Moran Financial Advisors, said after the inflation data was released.

In a research note, Morgan Stanley economists said that Wednesday's data "supports the view that the last few months likely marked the peak rates of inflation".

A peak in inflation rates would coincide with an expected peak in earnings growth for the second quarter. As at last Friday, with over 440 companies reported, S&P 500 second-quarter earnings are expected to have climbed 93.1 per cent, according to Refinitiv IBES data.

Steep increases in inflation and earnings growth "are telling you the same thing - which is a year ago things were really dire, and this year things are rebounding", said Sameer Samana, senior global market strategist at Wells Fargo Investment Institute in St Louis.

Mr Samana said stocks remained attractive over bonds as he still expects S&P 500 earnings growth of about 10 per cent in 2022 while interest rates remain low.

Concerns about inflation early this year drove a sell-off in Treasury bonds, lifting yields, while the stock market saw a rally in cyclical and value stock groups such as financials and energy.

Since the end of March, however, the yield on the 10-year Treasury note has fallen over 40 basis points, while the Russell 1000 value stock index has climbed only about 7 per cent against a 17 per cent rise for a counterpart index of tech and other growth stocks.

Ark Invest's Cathie Wood, whose Ark Innovation ETF was the top performing US equity fund last year, made the case in a webinar on Tuesday that falling lumber and oil prices signal that inflation has peaked; and that growth stocks will start to once again outperform as they did during the economic lockdowns in 2020.

Peter Cardillo, chief market economist at Spartan Capital Securities in New York, said the inflation data on Wednesday was positive for stocks. But he added" "Is the inflation scare over? Not by a long shot." REUTERS