Stock Market's Soft-Landing Rally is Being Tested by CPI Inflation. Here’s What Investors Should Do

The U.S. stock market kicked off the Halloween season with a positive tone, following an unexpectedly strong jobs report for September. The report gave investors hope that the economy could achieve a "soft landing," with inflation easing without a significant economic slowdown. However, it also caused market participants to rethink the possibility of future interest rate cuts by the Federal Reserve and wonder whether the central bank made an error by lowering rates by 0.5% last month.

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As a result, Wall Street is now eagerly awaiting this Thursday's consumer-price index (CPI) report, which could play a pivotal role in shaping the outlook for the U.S. stock market. A CPI report that indicates higher-than-expected inflation in September could slow the Federal Reserve’s pace of reducing policy rates and potentially disrupt the current stock market rally, analysts suggest.

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According to economists surveyed by The Wall Street Journal, headline inflation for September is expected to rise by 0.1%. Meanwhile, core CPI, which excludes volatile food and energy prices, is forecast to increase by 0.2%. Over the past 12 months, headline CPI is expected to drop to 2.3%, down from 2.5% in August, while core CPI is projected to hold steady at 3.2%.

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Nancy Tengler, CEO and chief investment officer of Laffer Tengler Investments, warned that the market could face risks if the Fed cuts rates too aggressively before inflation is fully under control. "We are seeing a modest but persistent upward trend in core CPI each month, and that's not the kind of broad disinflation we want to see across the economy," Tengler noted.

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One of the main contributors to inflation this year has been housing costs, which have remained stubbornly high. According to Tengler, this trend may persist, especially as China has implemented significant monetary stimulus measures that have driven up the prices of energy and materials. Additionally, concerns about inflation resurfacing have been fueled by recent geopolitical events, including tensions in the Middle East and a brief dockworkers' strike in the U.S., which could create supply chain disruptions.

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Brent crude oil prices, for instance, saw their largest weekly increase in two years last week, driven by escalating tensions in the oil-rich Middle East. Iran’s missile attack on Israel contributed to fears of further unrest in the region, potentially threatening global oil supplies. In the U.S., the now-resolved dockworkers' strike, which affected ports from Maine to Texas, also heightened concerns about supply chain interruptions.

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These developments came just days before the September jobs report was released, which brought relief to many investors concerned about the potential slowdown in the labor market. The U.S. economy added 254,000 jobs in September, surpassing expectations, and the unemployment rate dipped to 4.1% from 4.2%. The stronger-than-anticipated labor market data bolstered hopes for a soft landing, where inflation cools without triggering a recession.

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However, one element of the jobs report, a 0.4% increase in average hourly earnings, has reignited inflationary concerns. Combined with a "startling" wage agreement for port workers, some fear that inflation could remain an issue for the Federal Reserve, said Steve Wyett, chief investment strategist at BOK Financial. While the port workers' wage increase is unlikely to have a direct impact on overall wage levels, Wyett suggested that progress toward the Fed's 2% inflation target might remain slow.

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Nonetheless, some analysts believe that rising energy costs and the fallout from the brief port strike may only cause temporary disruptions to the current disinflationary trend. Luke Tilley, chief economist at Wilmington Trust Investment Advisors, argued that these events might drive up CPI in the short term, but are unlikely to cause sustained inflation in the U.S. economy.

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Mary Ann Bartels, chief investment strategist at Sanctuary Wealth, echoed a similar sentiment, stating that inflation should not be a major concern unless oil prices climb back to $100 per barrel. However, some options traders are betting that oil prices could soon hit that level amid fears that rising tensions between Israel and Iran could escalate into a broader regional conflict that disrupts crude oil flows.

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It’s important to note that financial market participants will not see the impact of any of these “October surprises” in this week's September CPI report. According to Mike Reynolds, vice president of investment strategy at Glenmede Trust, this could be the "last clean inflation data" before new economic cross-currents take hold in the coming months. He warned that if the CPI starts trending in the wrong direction, it could derail the stock market and the broader economy, although such a scenario is not the base case.

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Meanwhile, the third-quarter corporate earnings season is set to begin, with major financial institutions such as JP Morgan Chase, Wells Fargo & Co., and BlackRock Inc. scheduled to report results on Friday. According to John Butters, senior earnings analyst at FactSet, earnings for S&P 500 companies are expected to grow by 4.6% for the third quarter, down from the 7.8% growth projected in June due to downward revisions by analysts. However, Butters noted that a 4.6% growth rate would still mark the fifth consecutive quarter of year-over-year earnings growth for the index.

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Despite these lower earnings growth expectations, Tengler believes there is still room for "upside surprises," especially if profit margins improve. She suggested that the stock market could see a sharp pullback in October, which could present a buying opportunity for investors given the current bull market.

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On Monday, U.S. stock-index futures were lower amid a rise in Treasury yields, reflecting the ongoing uncertainty in financial markets.

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