Downside Risks Hidden in a 'Normal' Market Downturn: Morning Brief

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Stocks rose again on Wednesday, recovering part of the sharp losses they suffered on Tuesday after a hotter-than-expected headline inflation reading that morning. Small caps led the way, with the Russell 2000 (^RUT) rising more than 2% after suffering its worst day in years.

But the biggest question for investors remains: Was Tuesday's defeat just one incident or the beginning of something bigger?

The balance of evidence suggests that this is a short-term pullback with new record highs coming in a few weeks – in other words, a buying opportunity.

Regardless of how economic data arrives over the next few weeks, it wouldn't be unusual for the S&P 500 to pull back after a sharp 20% rise from its October lows, especially with where we are on the calendar.

As Ryan Detrick, chief market strategist at Carson Group, said: Marked with an XThe next four weeks on the calendar have not been historically great during the fourth year of a presidential term.

With the index rising 14 out of 15 weeks, a break is expected.

“Seasonal weakness is normal,” Dietrick wrote.

However, the tail risk is real, the downside risk is not trivial, and the best rules of the game feature very subtle nuances.

Overall, the narratives driving recent soft landing expectations have not changed significantly.

As Chicago Fed President Austin Goolsbee said on Wednesday: “Let's not get carried away when we receive one month of CPI that is higher than you expected.”

Meanwhile, earnings growth, the engine of any bull market, remains strong. Growth is not limited to the Great Seven, although they certainly help.

Moreover, most inflation measures are still trending downward. Tuesday's headline and core reading may have surprised forecasts to the upside, but year-over-year trends in both readings are trending lower.

The story continues

Given the reaction in Fed Funds futures, Tuesday's inflation surprise only erased half of the 25 basis point interest rate.

But looking at the CPI report and measuring some of the numbers over shorter time frames reveals some trends that are keeping some investors awake at night. So-called superinflation, which measures inflation in basic services after excluding housing, has risen sharply.

This measure of inflation, frequently mentioned by Fed Chair Powell, fell from an annual rate of 8% to 3% late last year, but has returned to 5.5%. “This is not good news for the markets.” Alfonso Picatelloowner of The Macro Compass, said in X.

If inflation turns more broadly higher, it could refocus on the “no landing” scenario that rattled investors and disrupted markets in mid-2023.

Meanwhile, expectations of Fed cuts are driving the boat, and the timing of those cuts is far less important than the fact that investors believe the next move is lower.

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