The U.S. Federal Reserve started its interest rate hike campaign in March 2022 after inflation had risen to an unprecedented level. Though inflation hit at record annualized rate of 9.1% in June of last year, prices have started to come down since then. For those looking to see how far the Fed has come in its fight against inflation, look no further than the CPI reports in June, July, and August the Bureau of Labor Statistics reported pricing pressures had come down significantly. Moreover, the August inflation report, in particular, exhibited positive developments in the labor market where the Fed has been the most concerned. While job growth in the United States picked up in August, wage growth moderated and the unemployment spiked to 3.8%.
All of that to say, while inflation has indeed trended downward, there are still three ways in which inflation impacts the stock market that investors should be aware about.
Inflation has eased but pain-points still exist
Stock investors have been enjoying a bull market since the beginning of 2023. Of course, this was not expected. Last year, equities in the U.S. could only be described as volatile and largely underperforming. The macroeconomic environment, already beleaguered with sustained supply chain bottlenecks from the pandemic, intensified in part by Russia’s invasion of Ukraine, causing commodities prices to elevate globally. Although supply chain bottlenecks have greatly dissipated, according to the Federal Reserve Bank of New York, commodities prices may be on the run again, threatening the U.S. Federal Reserve’s progress. Saudi Arabia and Russia will extend their oil production cuts until the end of the year and U.S. oil reserve figures have slipped downward, which will elevate crude prices in short and medium term.
The labor market, a major concern of persistent inflation, has showed mixed signs of cooling down. The August data showcased moderated wage growth, but the number of job openings for that month unexpectedly grew, thereby rattling markets. Still, initial labor market data for September showed the private sector added less jobs than expected.
Ultimately, nothing is yet set in stone, and as pain-points disappear and resurface, investors should expect corresponding volatility in the broader equities market.
Interest rates could stay elevated for longer
The debate about the ceiling for the Federal Funds rate, the benchmark interest rate in the U.S., continues unabated. Since the Fed’s eleventh rate hike in July, which saw the Federal Funds rate climb another 25 basis points (bps), Fed chairman, Jerome Powell, and other officials have adopted a ‘hawkish hold’ approach to their hike cycle. Sure, inflation has come down significantly, but not all Fed officials seem convinced. In their September meeting, Federal Reserve rate projections baked in another 25bps increase towards the end of the year. Whether this comes into fruition will be dependent upon the economic data that comes out in the following weeks.
Fed officials have also hinted rates are likely to be higher for ‘sometime’, which could place pressure on stocks in both 2023 and 2024. Interest rates tend to have a lagged effect on economic output and unemployment, so if they are to remain as elevated as they are for an even longer period of time, negative economic ramifications could surface, place both the state of broader economy and equities in jeopardy.
SMB-focused and consumer discretionary stocks could be most at risk
Persistent inflation and interest rates higher for longer could put unduly pressure on shares of public companies focused on servicing small-to-medium sized businesses (SMBs) and delivering consumer discretionary products. While SMBs are an important base of customers that could drive robust top-line growth figures, in times of higher interest rates, slowing economic activity, or other economic shocks, these businesses tend to be less resilient than their larger enterprise counterparts. This is why companies like Datadog (NASDAQ:DDOG), EverCommerce (NASDAQ:EVCM), and the recently IPO’d Instacart (NASDAQ:CART) – amongst many others I have written about in the past – have all experienced a decline in new customers or selling volume.
Similarly, consumer discretionary stocks, which rely heavily on consumers with disposable income, could be at risk as well, especially if rates remain elevated. The Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY), a consumer-focused exchange traded fund, has slipped nearly 10% since mid-September, most likely due to traders coming to terms with the viability of these companies’ business models as their customer base becomes more cash constrained. Student debt payments set to restart later this month also do not spell good news for American consumers.
On the date of publication, Tyrik Torres did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
