Stocks Edge Higher in the Run-up to US Inflation Data

Stocks continued to recover following last week’s sharp market downturn as investors eagerly awaited key inflation data that could influence the Federal Reserve's upcoming decisions on interest rates.

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Equities posted gains for the third consecutive session. Although the consumer price index (CPI) likely saw a modest increase in July, the annual inflation metrics are expected to rise at a slower pace. This recent easing in price pressures has strengthened the confidence of Federal Reserve officials that they can begin to lower borrowing costs while shifting their focus to the labor market, which has shown increasing signs of cooling.

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Chris Larkin of E*Trade from Morgan Stanley noted that the release of the inflation data comes at a pivotal time for the market. In just a few weeks, the discussion has shifted from concerns about whether the economy has slowed sufficiently to fears that it may be "stuck in the mud," he observed.

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"Investors will be looking for the data to hit a sweet spot—cool enough to reinforce the likelihood of a September rate cut, but strong enough to ease recent recession fears that have unsettled the markets," Larkin explained.

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Data from Deutsche Bank AG revealed that investors reduced their equity allocations at the sharpest rate since the onset of the COVID-19 pandemic during last week's market volatility. A historical analysis of past growth scares suggests that stock correlations and volatility will only gradually return to more normal levels, according to David Kostin of Goldman Sachs Group Inc.

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JPMorgan Chase & Co. strategists, led by Mislav Matejka, cautioned that the risk-reward outlook remains mixed over the summer, given the backdrop of weakening business activity and negative earnings revisions. They noted that a combination of economic uncertainty and a traditionally weak period for corporate earnings forecasts is likely to limit further gains in the stock market. Similarly, Michael Wilson of Morgan Stanley pointed out that these factors could cap the market's upward momentum.

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The S&P 500 hovered around 5,350, while the Cboe Volatility Index (VIX) remained stable at about 20. This followed an unprecedented spike in the VIX, which surged above 65 last Monday, leading some to question whether the index was exaggerating the level of stress in the U.S. stock market.

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Meanwhile, the yield on the 10-year Treasury held steady at 3.93%.

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According to Scott Rubner of Goldman Sachs Group Inc., investors may have a brief opportunity to buy the dip in U.S. stocks at the end of this month as selling pressure from systematic funds decreases and companies increase share buybacks.

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"This will be my last bearish call for equity markets in August as we are nearing the end of the worst period of the equity supply and demand mismatch for the month," Rubner, managing director and tactical specialist at Goldman Sachs, wrote in a note to clients.

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One indicator suggests that last Monday's market drama was more of a minor setback than a precursor to more significant problems.

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Consider the relationship between the Cboe Volatility Index and the option-adjusted spread on the Bloomberg U.S. Corporate Bond Index. Historically, a close of the VIX near 39 would correspond to a reading of 3.5% in corporate bond spreads. However, last week, bond spreads ended much lower, around 1.32%.

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This mismatch suggests that the recent market downturn was more technical in nature rather than a sign of impending economic trouble, according to Bloomberg Intelligence strategists Christopher Cain and Michael Casper. Historically, such abnormal disconnects have often led to above-average returns for stocks over the following three to six months.

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Tom Essaye of The Sevens Report shared his perspective, stating that he does not believe the fundamentals have deteriorated enough to justify de-risking or reducing equity exposure. However, he also advised against ignoring the recent uptick in market volatility.

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"Much of what I read over the weekend characterized this recent volatility as just a typical pullback in an upward-trending market," Essaye said. "Because of that, I continue to advocate for exposure to defensive sectors and minimum volatility funds."

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As the market digests the upcoming inflation data, investors will remain focused on how these developments will shape the Federal Reserve's policy decisions and the broader economic outlook. The balance between inflation concerns and economic growth will likely continue to drive market sentiment in the weeks ahead.

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