Inflation and War: Twin Monsters That Threaten Equities

The combination of elevated inflation and geopolitical risk poses a Scylla-and-Charybdis dilemma for investors.

In Homer’s epic tale, Odysseus and his shipmates were compelled to navigate the narrow waters between two mortal dangers: the sea monster Scylla and the devouring whirlpool Charybdis. It’s difficult to come up with a better metaphor for the twin dangers that investors face now.

As I explain below, the monsters of renewed inflation and overseas war are pushing up bond yields and weighing on equities. But I also highlight bullish factors as well.

Recent market sentiment has leaned towards caution. Contributing factors include deepening geopolitical tensions in the Middle East and Eastern Europe and the market’s adjustment to the Federal Reserve’s potential delay in interest rate cuts.

However, the positive outlook for first quarter 2024 corporate earnings results continues to provide support to the market.

The resurgence of rising rates has been a headwind for stocks, with the benchmark 10-year U.S. Treasury yield (TNX) surpassing 4.58%, its highest level since last November (see chart).

This sharp increase is driven by higher-than-expected inflation figures and robust economic data, prompting a reassessment of expectations for Fed easing throughout the year.

Hawkish speeches so far this week by several Fed officials have garnered bearish responses in the stock market. Although the Fed has paused on rates and acknowledged the possibility of future cuts, officials have emphasized the need for persistent evidence of declining inflation before considering easing policy further.

Despite recent equity pullbacks, I believe the rally still has legs over the long haul. Although the surge in bond yields has been rapid, I view it as an adjustment to the new Fed outlook rather than a sustained period of rising interest rates.

It’s likely that longer-term rates will gradually stabilize as inflation trends downward and the Fed moves closer to implementing rate cuts in the latter half of the year.

Corporate earnings growth: a bullish trend…

Earnings are a bright spot. For Q1 2024, with about 6% of S&P 500 companies reporting actual results, 83% of S&P 500 companies have reported a positive earnings surprise and 53% have reported a positive revenue surprise, according to research firm FactSet.

For Q1, the blended year-over-year earnings growth rate for the S&P 500 is 0.9%. “Blended” combines actual results with projections. That growth rate may seem unimpressive. However, if 0.9% turns out to be the actual rate for the quarter, it would mark the third consecutive quarter of year-over-year earnings growth for the index.

What’s more, history tells us that earnings as a whole typically outpace expectations. Indeed, based on the average improvement in the earnings growth rate during an earnings season, S&P 500 companies will likely report year-over-year growth in earnings of more than 7% for the first quarter. That’s a powerful tailwind for stocks.

As long as economic growth remains a pillar for corporate earnings, the market should withstand the postponement of anticipated policy easing from the Fed, barring any significant upturn in core inflation.

It’s also encouraging that the produce price index (PPI), which measures wholesale prices, has been cooler than the consumer price index (CPI) so far this year. PPI is a lagging indicator and this trend should eventually show up within future inflation readings.

In the meantime, the main U.S. stock market indices extended their slump on Wednesday, closing lower as follows:

  • DJIA: -0.12%
  • S&P 500: -0.58%
  • NASDAQ: -1.15%
  • Russell 2000: -0.99%

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John Persinos is the editorial director of Investing Daily.

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