Inflation data and US midterm elections to test mettle of struggling stock market rally

Wall Street's rebound dissipates some of the gloom that had pervaded since the Fed raised interest rates again

US Fed chairman Jerome Powell, said US policymakers will likely take rates higher than envisioned in their bid to crush inflation. AP

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A sputtering US stock rally faces a double-dose of potentially market-moving events next week: US midterm elections and inflation data that could influence the Federal Reserve's monetary policy.

Wall Street's rebound on Friday dissipated some of the gloom that pervaded since the Fed on Wednesday raised interest rates, while chairman Jerome Powell said policymakers will probably take rates higher than envisioned in their bid to crush inflation.

Nevertheless, the S&P 500 finished the week with a 4.6 per cent loss, likely burning many bulls that had jumped aboard an October rally that lifted the index more than 8 per cent from its lows.

A break of the index’s October 12 closing low would mark the fifth time this year that stocks have rallied by 6 per cent or more only to reverse course and plumb fresh depths.

Meanwhile, data from BoFA Global Research showed some $62.1 billion flowing into cash in the latest week, the largest inflows since the Covid-19 crash of early 2020, underlining pessimism that has prevailed among many market participants.

“We think we are on the path for a rocky landing for the economy, and next week we will get two pretty big clues as to what it's going to look like,” said Steve Chiavraone, head of multi-asset solutions at Federated Hermes, who is holding larger-than-normal allocations in cash and commodities.

Consumer price data has driven huge market moves this year, as surging inflation forced investors to ramp up expectations for Fed rate hikes. A stronger-than-expected reading on November 10 would possibly bolster the case for the Fed to continue.

Investors are now pricing in a peak of about 5.1 per cent for the Fed funds rate next year, compared with expectations of just under 5 per cent before the most recent Fed meeting. The central bank has raised rates to 3.75 per cent this year.

“If we get lower inflation reading then you could get a relief rally based on that data,” said Emily Roland, co-chief investment strategist at John Hancock Investment Management. In that case, however, “markets will be more focused on higher probability of a recession”.

Strategists at Wells Fargo believe CPI is more likely to fall short of expectations. They see the Fed’s terminal rate falling by 12 basis points or more if CPI comes in at a monthly gain below 0.4 per cent. Analysts polled by Reuters expect a 0.5 per cent monthly rise.

“All told, disinflationary forces are gathering strength,” Sarah House, senior economist at the firm, wrote on Friday.

At the same time, analysts said a surprise win by Democrats in the November 8 midterm election, which will determine control of Congress, could fuel concerns about more fiscal spending and inflation.

Republicans have been leading in polls and betting markets and many analysts believe the probable result will be a split government, with GOP control of the House of Representatives and possibly the Senate for the second half of Democratic President Joe Biden's term.

“If the Dems were to retain full control of Congress, you're more likely to see fiscal expenditures rise and that would be highly problematic in this inflationary environment,” said Spenser Lerner, a portfolio manager at Harbor Capital.

Options hedges on the S&P 500 imply a move of nearly 3 per cent in either direction on the day after the election, analysts at Goldman Sachs wrote this week, nearly twice the size of the average daily move the index has recorded this year.

Some investors are more hopeful regarding the period of stronger markets that past midterm elections have ushered in rather than on moves stemming from the vote itself: the S&P 500 has posted a positive return in the 12 months following all 19 midterm elections since the Second World War, according to CFRA Research.

Similar gains could be in store this time around — as long as inflation numbers are not hotter than investors expect, said Kei Sasaki, senior portfolio adviser at Northern Trust, who believes energy and financial stocks will perform well in a divided government.

“The results of the midterm will give greater visibility and help draw investor confidence higher,” he said.