Wall Street got a dose of good news this week. It also got a little ahead of itself.
Inflation slowed in July, according to Department of Labor data released on Wednesday. The consumer price index rose 8.5% in July from a year ago. That was lower than both the 8.7% increase in prices forecast by economists and the 9.1% reading in June.
That news sent the S&P 500 index up 2.1% that day and tipped the tech-weighted Nasdaq Composite into a bull market. The S&P closed the week up 3.3%, while the Dow Jones Industrial Average and the Nasdaq gained 2.9% and 3.1%, respectively.
It makes sense that investors would celebrate the easing of prices. But it may be too early to pop the Champagne -- inflation standing at 8.5% is still a long way from the Federal Reserve's target of 2%, and the Fed is likely to continue tightening until it is under control.
Even if inflation has peaked, it's likely to remain stubbornly high. "One good print isn't going to change the Fed's modus operandi," Richard Bernstein, CEO of Richard Bernstein Advisors, told Barron's. "The last thing they want to do is take the foot off the brake and have inflation come ripping back."
There are several reasons to believe that inflation will continue to be sticky -- even if it stays below multidecade highs. That means investors may be in for more market volatility through the end of the year. Wednesday's rally was seen largely in tech names and other more speculative assets like cryptocurrencies -- not what one would expect in a tightening cycle.
"The more you think tech is going to run, the more you have to think the Fed is going to have to tighten," says Bernstein, as it indicates a speculative mind-set not consistent with a cooling economy -- one that's also seen in other economic data.
July's jobs report blew past economists' expectations and showed that the demand for labor remains robust, which also means that businesses will probably have to continue to pay up to retain and attract workers. No one minds a raise until they realize the inflationary effects of wage increases leave them roughly where they started.
There's the fact that some of this apparent cooling comes as several cities in China are under Covid lockdown, meaning that there is less demand coming from the second-largest economy in the world.
It's tough to declare victory on commodity inflation with China still implementing its Covid-zero policy, Bernstein warns. "If China's economy is at six or eight cylinders and commodities are lagging, we've got something," he says. "We're at one or two cylinders." Indeed, commodity prices ticked up this past week: Brent crude flirted with $100 a barrel this past week, and copper prices have been marching higher.
Given the market's tendency to pull back after rallies in volatile markets, the risk-reward for getting excited about equities now is poor, points out BTIG Chief Market Technician Jonathan Krinsky.
With markets likely to be volatile for some time as the effect of interest-rate hikes and inflation works its way through the system, bet on two things: The Fed will continue to be aggressive, and profits will decelerate. Speculative names may be tempting following any dose of good news, but investors will be better off sticking with defensive sectors that offer stable growth, such as consumer staples, utilities, and healthcare.
Those sectors may also see volatility, but demand won't dwindle dramatically in a downturn.