Did inflation deliver knockout blow in stocks’ ‘Fight the Fed’ battle?

Maya Angelou's name probably doesn't come up too often in the typical conversation on Wall Street, but the celebrated African-American poet nonetheless has some sound advice on relationships that investors perhaps should have heeded these past few weeks.

"When someone shows you who they are, believe them the first time," she famously wrote, underscoring the danger of assuming people alter their behavior or beliefs to suit your personal needs.

The Federal Reserve has been telling investors for weeks, some would argue months, that betting on spring rate cuts is a risky endeavor, with Chairman Jerome Powell going as far as specifically removing the chances of a March reduction at his most recent news conference in January.

Markets haven't truly believed him, however, nor the "higher for longer" mantra of his rate-setting colleagues on the Fed's policy-setting Open Market Committee, despite virtually all the panel members having made public remarks over the past two weeks preaching patience on rate cuts and concern about stubbornly high inflation.

Investors didn't believe Powell the first time, but they should believe him now.

Markets are now split as to when, or indeed whether, the Fed will start cutting rates this spring.TheStreet / Shutterstock

Core inflation, which the Fed tracks more closely than headline price pressures because it removes volatile components like food and energy, held steady at 3.9% last month, nearly double the central bank's 2% target.

Hot inflation, hotter economy

On a monthly basis, core prices rose 0.4%, the most since last spring, while headline inflation eased only to 3.1% despite overall declines in gasoline prices and the traditional price-cutting that typically follows the holiday season.

Set against an economy that is growing at a 3.2% clip, according to real-time data from the Atlanta Fed's GDPNow forecasting tool, and a job market that added 353,000 new hires last month with wages rising the most in nearly two years, inflation concern is suddenly back in fashion on Wall Street.

"The biggest fear any bull should have is economic growth, but a close second would be that inflation that remains sticky," said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance in Charlotte.

Related: Inflation surprise revamps Fed interest rate outlook

"The initial reaction from the stock and bond markets should be to sell off; bonds are too expensive if inflation is still a problem, and the stock market can't keep rallying if rates are going to be higher-for-longer – especially if the assumption that the Fed is completely done raising rates is incorrect," he added.

The "sell" part is surely correct: The S&P 500 tumbled 69 points, or 1.37%, by the close of Tuesday trading, tipping the benchmark into its worst single-day decline since March. The index was up just under 5.4% for the year before the January inflation report and had topped the 5,000-point mark for the first time on record last week.

Investors looking for a way out

Benchmark 10-year Treasury note yields, meanwhile, surged to an early December high of 4.316%,, while 2-year notes, which are the most sensitive to interest-rate changes, lurched 18 basis points higher to 4.654%.

However, markets may have been looking for a trigger to sell, given that only a handful of tech-sector heavyweights have powered much of the S&P 500's year-to-date gain. Another factor: Stronger-than-expected fourth-quarter reports have left the benchmark trading at its richest price-to-earnings multiple, 20.4, in over two years.

But today's inflation report could represent a bigger change in investor perceptions now that the bulk of the S&P 500 has reported and the next Fed meeting is more than a month away.

"While markets are focused on when the first rate cut will be, we believe that any delay until May/June would indicate that both the jobs market and the economy are holding up very well," said Larry Tentarelli, chief technical strategist at Blue Chip Daily Trend Report.

Related: Fed members just hat-tipped what's next for interest rates

"The Fed wants to avoid any uptick in inflation, and cutting rates too early could raise that risk," he added, noting that holding rates in place for longer gives the Fed "an ample amount to work with" if the economy slows markedly into the summer and beyond.

Strong job market and resilient consumers

There's little sign of that just yet, given both the strength of the job market and the broadest resilience of the domestic consumer.

Coca-Cola (KO) posted stronger-than-expected December-quarter sales of $10.95 billion on Tuesday, topping Wall Street forecasts, thanks in part to the drinks giant's ability to pass on price increases of more than 7%.

Restaurant Brands International (QSR) , the owner of Burger King, Popeye's, and Tim Horton's, also posted Wall-Street-beating sales of $1.82 billion Tuesday. Big gains in U.S.-store traffic offset declines in international markets, especially in the Middle East.

That could mean an even longer delay in lower rates. The Fed is expected to issue new growth and inflation forecasts and its so-called dot plot projections at its March policy meeting.

"Even the Fed, which got the 'transitory' call so wrong, has learned their lesson and has been cautious about lowering rates prematurely, because they are worried that inflation will get 'stuck' and not move in a measured way straight down to their 2% target," noted Zaccarelli of Independent Advisor Alliance.

Still, that might not mean the end of the line for stocks.

It might not be over yet: Big investors are bullish

Bank of America's closely tracked survey of global fund managers, published Tuesday, indicated the strongest level of equity market optimism in two years, with investors cutting cash holdings and plowing into stocks.

Global stock allocation is also at a two-year high, the survey noted, with the biggest holdings of U.S. stocks since November 2021 and the biggest overweight in the tech sector in more than 3 1/2 years.

The earnings season is also solid, with analysts expecting collective profits to rise more than 9% to a share-weighted $473 billion, with a further 5.4% advance over the first three months of this year.

Beyond that, some economists say, the January inflation report might not be the haymaker it's being made into.

More Economy:

Analysts revamp interest rate targets following Fed meetingBond markets' reaction to key data could be great for stocksJobs report shocker: 353,000 hires crush forecasts, stokes inflation fears

"Consumers are seeing a lot of relief from inflation among price categories that change rapidly, like gasoline and used cars, and less relief for services whose prices change slowly, like car insurance, restaurant prices, hospital services," said Bill Adams, chief economist for Comerica Bank in Dallas.

"Even so, the direction of travel is unmistakable: The last few months have seen big improvements in privately conducted surveys of consumer confidence, [and] households expect that improvement to broaden over coming months," he added.

If that proves true, markets could have plenty of time to recover from the current pullback.

"Considering these positive longer-term fundamental dynamics, we encourage new money to be patient and existing money to use any market weakness as an opportunity to rebalance portfolios back to targeted allocations," said Comerica Wealth Management's chief investment officer, John Lynch.

"The combination of easier financial conditions, steady economic growth, and continued corporate profit growth should enable the equity markets to regain their footing after a period of volatility," Lynch said.

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