Stocks are off to a strong start in 2023 after last year's selloff, with cooling inflation a pillar of support.
But there's stickiness in services inflation, and that poses downside risks for equities, analysts said.
Wage growth has eased but an even slower pace would suit the Fed's inflation-fighting goal.
A downward trend in inflation has made for a bullish backdrop for stocks in 2023, but market watchers caution that persistent price strength in a key portion of the world's largest economy may stop the latest rally in its tracks.
The final full trading week of January rounded off with another inflation gauge – this time, the Federal Reserve's core Personal Consumption Expenditures Index released Friday - showing deceleration from stronger levels. Earlier this month, the closely watched Consumer Price Index showed prices at 6.5% in December. That's come down from a peak of 9.1% last year.
A downside scenario for stocks would be the emergence of a "head fake" in inflation, Jason Draho, head of asset allocation for the Americas at UBS Global Wealth Management, told Insider. "Meaning the data will look like it's moving in the right direction … but then, lo and behold, you get to the springtime, and it turns out that inflation fell to 4% and now it's plateaued," he said.
Easing headline inflation figures have helped lay the groundwork for equity gains as 2023 gets underway. The Nasdaq Composite has popped 11%, and the S&P 500 has risen more than 6%. The indexes in 2022 tumbled by 33% and 19%, respectively, with valuations crashing as inflation hit 40-year highs.
But there are signs that prices remain somewhat stubborn on the services side of the economy, an area of emphasis among policy makers on the Federal Open Market Committee. Services drive more than two-thirds of activity in the US economy.
"To the upside, inflation of sticky prices like violin lessons, veterinarian fees, car repairs, and other services provided by small businesses and sole proprietors was still accelerating in late 2022—and that stickiness could make inflation rebound later this year or in 2024 as growth gets back on track," Bill Adams, chief economist at Comerica Bank, wrote in Friday note about the PCE report.
The Fed has been zeroing in on wage growth, Draho said. Pay for workers is a significant driver of costs for businesses such as retailers and restaurants. Average pay for Americans has slowed in recent months, but the Fed would like to see more, Draho said. Annual average hourly wage growth was 4.6% in December.
"The risk is that if the Fed were to ease up [rate hikes], the economy could re-accelerate and inflation goes higher," Draho said.
Wages may be sticky with continued tightness in the labor market. Weekly jobless claims last week fell by 6,000, and applications for employment benefits are still near pre-pandemic lows.
For now, the equity market looks priced for an economic soft-landing outcome, said Draho. UBS GWM has a 4,000 price target on the S&P 500, implying the broad index will end 2023 slightly lower.
The Fed could be comfortable with wage growth sitting below 4% and inflation at its 2% target without seeing a dramatic rise in the unemployment rate, Draho said. "And there's no historical precedent for that happening," he said.
Inflation currently is arguably the most important variable in determining the direction of the broad market and underneath that, where investors should put their money, John Porter, chief investment officer of equities at Newton Investment Management, told Insider.
"If I knew with complete clarity that by the second half of the year we are going to see a CPI number consistently with a 2% handle, that would give me a lot of optimism around equities [and] the growth part of the market," said Porter.
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