Inflation Risk Spooks Equity Markets

US inflation for January surprised on the upside today. CPI inflation was at 2.1% y/y and Core inflation at 1.8% y/y. Both are above the consensus of 1.9% and 1.7% respectively. This adds to the fear of further turmoil in the equity markets.

A couple of weeks ago we warned that inflationary risks had increased in the US and that this could trigger a downturn in the US stock market. The warning was brought by Bloomberg and can be read here. As we know today that was the correct call.

To a large extent, the timing of this was luck, but there is no doubt that the inflationary story is now very much in focus in the markets. For the first time since 2008 markets are now fundamentally becoming concerned that the Federal Reserve will overshoot it’s 2% inflation target. This is exemplified in our 2y2y inflation forecast for the US which has reached 2.1%. While it is only slightly above the Fed’s 2% target, it is the first time since 2012 that our Monetary Indicator is signaling a higher risk of overshooting rather than undershooting the inflation target. Looking at market-based inflation expectation substantiates these worries.

The drop in S&P500 over the last weeks means that our valuation model now no longer says US stocks are overvalued. However, our Monetary Indicator pretty clearly shows US monetary conditions are too easy. As seen below, the risk of Fed starting to hike rates more aggressively than already priced in is becoming more likely.

In that sense, the situation is somewhat different from for example in early 2016 where the Fed had moved too early and could step back a bit when the stock market sold off. That is no longer a possibility. Inflation expectations have now jumped and there is no room for the Fed for a more dovish stance. This in our view means that there are more downside risks for stocks and a risk of more volatility. 

Right now, our models are flashing “dollar strength” and if that were to happen then we certainly will see more volatility. It is also notable that so far other risky asset classes have held up surprisingly well. If the dollar starts to strengthen that certainly will change. That said, the dollar is probably more or less where it should be in the medium-term.However, if the Fed starts to turn more hawkish in response to the upwards pressure on inflation, markets could be in for more turmoil.