The recovery of the US stock market will be put to the test by inflation

The rise that brought US stocks back from the brink of a bear market will be put to the test next week, when consumer price data will reveal how much more the Federal Reserve will need to do to combat the worst inflation in decades. Despite a rough week, the S&P 500 is still up more than 5% from last month’s lows, which saw the benchmark index drop over 20% from its all-time high. After dropping 1% in the previous week, the index was down around 14 percent from its January 3 high.

More upside may be contingent on investors’ belief that officials are making success in combating rising costs. Signs that inflation is still high might reinforce the case for even more aggressive monetary tightening, potentially spooking a market already shaken by fears that a hawkish Fed could wreak havoc on the US economy.

“Until we see a major shift lower in inflation, this market is likely to stay range-bound,” said Mona Mahajan, senior investment strategist at Edward Jones, which currently favours large-cap stocks over small-cap stocks due to larger companies’ ability to withstand greater input and salary expenses. “Clearly, the print next week will be crucial.” The consumer price index (CPI) climbed 8.3 percent in the 12 months ending in April, down from an 8.5 percent annual rate recorded the month before, which was the biggest year-on-year increase in 40 years. The May inflation report is one of the final major pieces of information before the Fed’s meeting on June 14-15, when the central bank is largely expected to hike rates by another 50 basis points.

“If inflation continues to be a problem,” Paul Nolte, portfolio manager at Kingsview Investment Management, said, “the Fed may not have the option of coasting later this year.” Nolte has reduced equity exposure in his portfolios, particularly in growth stocks, and increased cash balances, citing issues such as still-high market valuations.

The CPI report comes as investors assess the impact of the Fed’s 75 basis point monetary tightening already implemented this year on growth. US firms recruited more workers than expected in May and maintained a strong rate of wage rises, according to employment data released Friday, indicators of strength that might keep the Fed on an aggressive monetary policy tightening path.

Meanwhile, numerous senior corporate leaders, including Jamie Dimon of JPMorgan Chase and Elon Musk of Tesla, have expressed pessimism about the central bank’s ability to control inflation without harming the economy. Musk stated in an email to executives that he has a “very awful feeling” about the economy and that the electric carmaker needs to slash approximately 10% of its workforce.

Higher prices have historically prompted the Fed to raise interest rates, with higher bond yields decreasing the value of future corporate profits. Investors’ views on inflation are essential to how they value shares. Consumers and corporations both face higher costs as a result of rising pricing. According to Jeff Buchbinder, equities strategist at LPL Financial, the S&P 500 trades at about 18.7 times trailing 12-month earnings, a high valuation compared to prior inflationary periods that signals investors fear the present level of price increases may not endure.

LPL predicts that inflation will begin to reduce this year, and that corporations will continue to do well. The firm’s year-end target for the S&P 500 is between 4,800 and 4,900, which is approximately 16 percent higher than the index’s current level as of Friday afternoon.

Others, on the other hand, have been more pessimistic. Morgan Stanley strategists termed the latest rise a “bear market rally” earlier this week, predicting the S&P 500 would tumble to about 3,400 by mid-August, citing poor earnings and economic signs. “Everyone agrees that the high prints or peak inflation numbers are likely in the rearview mirror,” said Art Hogan, chief market strategist at National Securities. “If that turns out not to be the case, markets will be thrown into disarray.”