U.S. Inflation Hits Three-Year Low, Yet Stocks Slide Amid Rate Cut Speculation

Americans received some relief in June as U.S. inflation fell to a three-year low of 2.97%, surpassing expectations. The Bureau of Labor Statistics reported a 0.1% month-over-month decline, raising hopes for potential Federal Reserve rate cuts later this year.

U.S. Inflation Falls to 2.97% in June, Surpassing Expectations and Raising Hopes for Fed Rate Cuts

Americans are finally experiencing some minor respite after years of grappling with the increasing cost of living. The Bureau of Labor Statistics reported that U.S. inflation decreased by 0.1% month-over-month in June, surpassing the consensus forecast of a 0.1% increase among analysts. Consumer prices increased by 2.97% annually, the lowest increase over three years.

“Expectations were that this was going to be a good report. But as you can see, it was better than expected,” Bill Sterling, global strategist at GW&K Investment Management, told Fortune of the consumer price index (CPI) data.

The primary cause of the June inflation decline was a 3.8% decrease in petroleum prices. However, core inflation, which excludes more volatile food and energy prices, was also lower than anticipated. Core inflation increased by only 0.06% month-over-month and approximately 3.3% from a year ago, marking another three-year low.

Professional investors have consistently predicted that the Federal Reserve would prevail in its battle against inflation even though the central bank has been battling inflation with relatively high interest rates for years. However, they have been repeatedly deceived. This time, numerous experts think that the Federal Reserve has successfully managed inflation and that interest rate reductions are imminent.

“All in all, it was a very encouraging report from the point of view of the Fed. And markets are pretty convinced now that this tees up a Fed rate cut in September,” Sterling said.

Wall Street Optimistic After CPI Report, Anticipates Fed Rate Cuts Amid Shifting Market Trends

Wall Street characterized itself with an optimistic outlook after the CPI report. Veronica Clark, an economist at Citi, observed that June inflation was "below already soft expectations," suggesting that the higher-than-expected inflation observed in the first quarter was likely "an aberration." Clark argued in a note to clients that the Fed should have the authority to reduce rates by September, particularly in light of the diminishing impact of shelter inflation.

For years, Fed chair Jerome Powell has been plagued by shelter inflation. However, numerous analysts and economists, including Jeremy Siegel of Wharton, have observed that the Fed's measurements have been slower than the actual reality, which has seen a decline in the growth of home and rent prices.

Eric Pachman, the chief analytics officer at Bancreek Capital Advisors, thinks there is compelling evidence that the shelter metric is gradually adjusting to reflect current prices. This is crucial because shelter inflation accounts for approximately one-third of the consumer price index.

“We finally have at least one data point to hang our hat on. So, maybe I'm overreacting, but I'm pretty excited,” he said of the shelter inflation data.

According to Brian Rose, senior U.S. economist at UBS Global Wealth Management, the recent increase in the unemployment rate could also provide additional ammunition for Fed officials to turn dovish. He reiterated Clark and Pachman's optimistic comments: "The Federal Reserve is now in a position to begin reducing rates, as both inflation and the labor market are softening."

After the CPI report, the probability of a July interest rate cut, as determined by Fed funds futures contracts, which offer insight into the expectations of bond market investors, increased; however, it remains below 10%, according to CME's FedWatch tool. Nevertheless, the probability of a September reduction has increased from approximately 50% following the CPI report from last month to 98%. By December, the likelihood of at least one rate reduction is nearly 100%.

Interest rate reductions are generally perceived as a positive development for equities. Companies can allocate additional funds to their expansion initiatives due to decreased financing costs, which indicate lower rates. However, two of the three leading indices experienced a decline following the excellent CPI report, which showed that rate cuts are more probable than ever.

The Nasdaq, characterized by its technological prowess, experienced a 1.95% decline, while the blue-chip S&P 500 experienced a 0.88% decline. However, it is intriguing that an equal-weighted variant of the S&P 500, which does not prioritize companies based on their market capitalization, experienced an increase of over 1.21%.

“Is the market down? Or is this the most extreme rotation that we've ever seen out of everything that people have been hiding in?” Bancreek Capital Advisors’s Pachman asked when faced with this data.

He observed that the majority of stocks did not experience a decline on July 11; however, the giant tech and AI-linked stocks that have generated investor enthusiasm in the past two years did. This is not a widespread stock market decline; instead, it is a transition by investors to more value-oriented investments, a trend that has been anticipated for some time.

Major Tech Stocks Plunge as Investors Shift to Value-Oriented Small and Mid-Cap Equities

On July 11, the shares of major technology companies, which have experienced significant growth in recent years, experienced a considerable decline, resulting in one of the most concentrated markets in history. Apple experienced a 2.3% decline, Microsoft experienced a 2.5% decline, Tesla experienced an 8.4% decline, and Nvidia experienced a 5.6% decline.

Pachman was not the sole individual who diagnosed investor rotation. In a post on X (formerly Twitter), Eric Wallerstein, the chief investment officer at Yardeni Research, expressed his conviction that "the great rotation" may be in progress. On July 11, Wallerstein observed that investors en masse transitioned from growth-oriented large caps to primarily value-oriented small and mid-caps.

Given that the S&P 600 small-cap index is trading at a mere 13.9 times forward earnings, and the large-cap S&P 500 index is trading at over 21 times forward earnings, this is not wholly illogical. Small caps, which have an average of significantly more debt than their large-cap counterparts, have been adversely affected by a higher-rate environment; however, this may be about to alter.

The market has been rallying in anticipation of rate cuts throughout 2024, which is the second possible explanation for the pain in stocks after the bullish CPI report, particularly in large tech and growth stocks. The S&P 500 is still up approximately 17% year-to-date despite its July 11 decline, and the Nasdaq Composite has risen by approximately 23% in response to AI growth.

“Stocks have been on such a tear for such a long time, you could argue that [the] good news was already baked in the cake,” Sterling of GW&K Investments explained.

To his point, inflation is not unexpectedly decreasing, especially considering the significant declines in numerous previously popular price categories. Consequently, innumerable investors have probably factored in declining interest rates when making stock valuations. For instance, lumber futures prices have dropped by over 75% from their 2021 apex. Or used vehicles, where the average cost nationwide has decreased from its 2022 peak of over $30,000 to a mere $25,328.

Ultimately, it is possible that market participants heeded the traditional Wall Street maxim that was imparted to novice investors on July 11: "Buy the rumor, sell the news."