A brighter start to the week, but can it last?

This is one of the most pivotal weeks of the year so far, it will ultimately tell us if the stock market rally that shocked financial markets can last, and whether the Fed is right to slow the pace of interest rate hikes and potentially stop hiking in the next few months. The pivotal moment will come on Tuesday when US CPI is released, it is closely followed by US retail sales, which will deliver a much-needed update on the health of the US consumer. Stock markets stumbled last week, the S&P 500 fell 1.1%, its first weekly loss of the year, as the market struggles to find a narrative to run with.

Outflows sound warning signs for US equities

Some context as we start a new week, investors are starting to run scared when it comes to US stock market ETFs. Investors have pulled a net $31bn from US equity mutual funds and ETFS in the last 6 weeks, which, for 5 out of those 6 weeks, the stock market was rising rapidly. This is the longest streak of outflows since the summer, and the most money pulled since 2016. So, what is going on? To answer this, it helps to know where the money is going. At the same time as ditching US funds, investors have bought international equity funds and municipal bonds. This suggests that investors are not convinced that the stock market rally will persist, and it could be a sign that market sentiment is turning, after the S&P 500 rose some 6.5% since the start of the year.

Investors preferences as we move through 2023

Investors are turning to safe assets like bonds, and cheaper foreign equities. However, investors are also making savvy financial decisions this year. For example, the Bloomberg aggregate US bond fund index is yielding 4.5%, this compares with a dividend yield of just 1.7% on the S&P 500. Of course, some of the US’s largest companies are engaging in mega buybacks, for example, Exxon and Chevron, which will help to boost their share prices. However, it appears that even these decent-sized sweeteners are not enough for investors in the current environment. Added to this, the price/ equity ratio of the S&P 500 is 18 times, this compares to 13 times for the Eurostoxx 600, and 10 times for the Hang Seng. Thus, it makes sense that investors are trying to exit at the peak and ride waves elsewhere as we progress throughout Q1.  

Tesla attraction in full force

Investors are reassessing the prospects for the S&P 500; however, they have not ditched stocks entirely, and there has been a notable increase in single stock purchases this year. Interestingly, Tesla shares have accounted for one third of all single stock purchases in 2023 so far which has helped Tesla’s share price to surge more than 60% this year. Is this a sign of a speculative bubble, or is it an opportunity to buy a quality stock at a discount, after the major rout in Tesla in 2022?

Geopolitical risks overplayed at this stage

Back to the key data releases this week, geopolitics are also on the back of investors’ minds, as the US continues to shoot down unidentified flying objects from its air space. Added to this, the UK is conducting its own internal investigation into how safe we are from foreign spying attempts. Quite frankly, this story seems ridiculous at this stage, as there has been very little information released with each shooting, in fact the press is reporting that the US pentagon is not ruling out UFOs. Thus, we think that at this time, the key focus for markets will remain the economic data releases.

US CPI to drive market sentiment this week

US CPI data for January is released at 1330 GMT on Tuesday. The market is expecting a 0.5% monthly pick up in headline CPI, higher than the 0.1% increase in December. The annual rate is expected to come in at 6.2%. Core prices are expected to rise by 0.4% on the month, with the annual rate expected to moderate to 5.5% from 5.7% in December. If this happens, then the market will likely be ameliorated, and there could be less anxiety around the Fed’s expected pivot later in Q2. Whether or not a further moderation in the US inflation rate will spur a return to inflows into US equity indices, could depend on whether investors are still interested in value? If they are, then the US still looks expensive, so it may require more than a further fall in inflation to woo investors back to US index funds.

Super core inflation in focus

When it comes to inflation, it’s worth remembering that the Fed is likely to focus on super-core inflation, which mainly focuses on the price of services, such as barbers, lawyers, and plumbers, and excludes energy and shelter costs. Thus, we expect analysts to focus on this measure, more than the broader headline and core figures. Thus, there could be some market volatility in US stocks, bonds, and the USD in the immediate aftermath of this report, as the market picks out the super core data set that is closely watched by the Fed. Super core inflation is currently around 4.1% in the US, so the market will be looking for a decent drop from here before it can be truly considered to be a risk-positive report.

Economic data round up

Elsewhere, US retail sales are expected to rebound in January, jumping 1.6%, reversing the 1.1% decline in December. Ex autos, which is considered a truer evaluation of the health of the US consumer, is expected to see a 0.7% increase, which, if accurate, suggests a stronger consumer than the Fed may want to see at this stage of its hiking cycle.

UK CPI is expected to fall to 10.2%. Core inflation is expected to rise to a 6.4% annual rate from 6.3% in December. If this is true, then it suggests that the BOE has more work to do, and we could see a re-pricing of UK bonds and an upward bias for the pound. In Europe, the EU’s latest growth forecasts showed that the currency bloc is expected to avoid recession this year and grow at an upwardly revised 0.9% rate. This is up from its previous forecast of a 0.3% annual growth rate. This further leaves the UK looking like the sick man of Europe, something that must be weighing on Rishi Sunak’s mind as people evaluate more than 10 years of Tory rule and the effects of Brexit, something he supported. Favourable developments in the EU’s forecast also include lower inflation than previously expected and the EU is also predicting that it will return to its strict fiscal rules by the end of the year, after suspending them during the pandemic. Thus, expect EU growth in some regions, to be given an extra boost by one last hoorah of government spending before these rules kick in later this year.

To conclude

Overall, the market’s animal spirits have been tamed in recent days as concerns growth that the Fed may delay rate cuts. Added to this, markets are cautious and a little scared about the outcome of Tuesday’s US inflation report. It’s a binary outcome: lower inflation is good for risk, higher than expected inflation is bad for risk. Keep the hard hats nearby if inflation fails to fall further in January.