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Stock Market Optimism Amidst Slowing U.S. Inflation: A Closer Look
US Dollar Strength Decline Is Good For Global Economy
Latest CPI Release
The latest inflation data showed that the CPI rose by just 3% in a year, marking the smallest increase since March 2021, compared to forecasts of 3.1%. Core inflation, which excludes volatile food and energy prices, also came in lower than expected at 4.8% compared to forecasts of 5%. This is significantly above the Federal Reserve's long-term goal of 2%.
The process of reducing inflation from high levels to more manageable ones is complex. It is easier to reduce inflation from 9% to 4% than from 4% to 2%, indicating that the most challenging part of controlling inflation is yet to come.
Economists suggest that the next phase of disinflation will require some loosening in the U.S. labor market, which may necessitate a weaker overall economy and could test the Federal Reserve's resolve to stay the course..
In contrast to the U.S., other countries are facing different inflationary pressures. The UK is grappling with an inflation rate of 8.7%, while China's economy is on the brink of deflation.
Stock Market Reaction
The recent slowdown in U.S. inflation has sparked optimism in the stock market, driving the S&P 500 above 4,500 for the first time in over 15 months. This surge was prompted by lower-than-expected inflation data in June. The improved economic outlook has led some experts to predict that the S&P 500 could reach an all-time high later this year. This optimism is based on the resilience of the economy and expectations for the nominal GDP to range between 5% and 7% this year.
The deceleration in U.S. inflation has also impacted global markets. The FTSE 100 index, which represents the 100 companies with the highest market capitalization listed on the London Stock Exchange, experienced its largest one-day increase of 2023, rising by 133.5 points to reach 7,416 points.
In the broader market context, gold prices have dipped slightly while oil prices remain flat. The Treasury market responded to these developments with an increase in Treasury yields.
While falling inflation rates have had a positive impact on the stock market, there are differing opinions on its future direction. Some expect a drop soon while others believe the U.S. may already be in a new expansion phase. However, challenges such as potential tightening of credit conditions could impede the stock market rally.
To sustain the upward trend in stocks, there needs to be a change in policy and strong earnings reports. However, if the Fed continues to raise interest rates after July, it could negatively impact the US economy.
Federal Reserve Implications
The Federal Reserve's campaign to raise interest rates may be nearing its end, potentially fueling the stock market rally. Futures markets indicate that investors anticipate one further 0.25 percentage point rate rise from the Fed's current target range of 5 to 5.25 percent by autumn. However, they expect the central bank to cut borrowing costs six times to around 3.8 percent by November 2024.
The Fed's balance sheet has been shrinking after expanding in March to provide liquidity to regional banks through an emergency loan program. This program injected over $300 billion into the marketplace, helping prevent a credit crunch, which is a sudden reduction in loan availability or tightening of loan conditions.
Despite a lower-than-expected CPI in June, Federal Reserve Governor Christopher Waller supports two more rate hikes this year. He believes that inflation data is not the sole factor driving the Fed's decisions and emphasizes the need for broad impact across goods and services sectors. Several more months of weak inflation readings may be needed to convince the central bank that its job is largely done. One positive data point does not mean inflation has been completely conquered.
The easing of U.S. inflation has had a global impact, causing the dollar to weaken further. The ICE U.S. Dollar Index, which measures the value of the U.S. dollar against a basket of foreign currencies, fell to its lowest close since April 2022. This decline, influenced by lower interest rate expectations, has resulted in the dollar experiencing its worst week since November, with a drop of 0.8% and an overall decline of 2.5% since last Friday.
The weakening U.S. dollar is contributing to a positive outlook for risky assets. A weaker dollar can also make U.S. goods more attractive to foreign buyers, potentially boosting exports and economic growth. However, it can also lead to higher inflation as imported goods become more expensive.
There is cause for concern in the economy due to the decrease in income tax payments and the deceleration of consumer price increases. The correlation between these two factors suggests potential underlying issues leading to a possible slowdown. This is further supported by the recent Consumer Price Index (CPI) numbers and a decline in the core rate.
The decrease in tax receipts could be attributed to a decline in hours worked and overtime hours, despite an increase in wages. This decline in incomes and spending has significant implications for the economy, suggesting that the new normal established during the pandemic was unsustainable without a continuous influx of money into the economy.
If federal tax receipt numbers are accurate, we can expect to see a further decline in the CPI in the coming months. There is even a possibility that the CPI may go negative, which would pose a major problem for the Federal Reserve.
The decrease in inflation can largely be attributed to a fall in energy prices, which had surged in 2022 following geopolitical tensions. Higher interest rates has slowed down the global economy and reduced consumer and business demand. This decrease in demand has allowed congested global supply lines to clear up, alleviating upward pressure on prices. Energy prices have fallen by 16.7% over the past year, with gas prices specifically dropping by 26.5%.
Shelter prices, particularly owner's equivalent rent, have been a significant driver of inflation. However, these prices have started to decline, which was expected due to the typical lag of 12 to 18 months after housing prices start to decrease. Rent and home prices surged in 2022, contributing to the highest level of inflation since the early 1980s. Rents have increased by 8.3% in the past year.
U.S. wholesale prices rose by a modest 0.1%, indicating a deceleration in inflation. Economists had predicted a 0.2% increase in the producer price index (PPI), which measures the average changes in prices received by domestic producers for their output.
The cost of groceries remains high, with a 4.7% increase compared to the previous year. The cost of dry grocery items like cereal and snacks has increased by 11% compared to the previous year, while frozen-section items are up by 7%.
Medical care and recreation services remained unchanged, while transportation services increased by 0.1% and education services fell by 0.3%. Service prices, excluding rent, have been relatively flat since January, indicating easing inflationary pressures in these areas.
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