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Why the latest inflation report was the best-case scenario for stocks

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  • Stocks rallied Tuesday after November inflation data came in cooler than expected.
  • The reaction shows traders are expecting an easing of Fed tightening, which would help avoid a hard economic landing in 2023.
  • The report was in many ways the most ideal possible outcome for stocks.

November inflation data came in cooler than expected.

It was in many ways the best-case scenario for stocks, as evidenced by Tuesday’s sharp rally. 

Cooler economic data signals the Fed’s rate hikes are working, and suggests the central bank could decelerate the pace of increases sooner than expected. This, in turn, reduces the prospect of an economic hard landing in 2023 and makes a looming recession possibly less severe. 

All that provides optimism to investors and juice for a stock rally — even with the Fed expected to announce a 50-basis-point rate hike Wednesday, its fifth jumbo move in a row. The strong upside move shows traders are already looking past this week’s rate decision towards a more measured path ahead.

“Today’s inflation report is a welcome holiday gift to markets,” Matt Peron, director of research at Janus Henderson Investors, wrote in client note. “While inflation is still unacceptably high, it is clearly dropping due to the lag effect of the rate hikes implemented this year. Today’s report is a clear positive for market multiples.”

The Labor Department reported that November CPI, which measures a broad basket of goods and services, rose 0.1% from the prior month, and 7.1% year-over-year. Dow Jones economists had expected those figures to increase 0.3% and 7.3%, respectively. 

Investors cheered on the reading, with the Nasdaq in particular rocketing higher. The tech-heavy index climbed as much as 4%. The S&P 500 and Dow Jones Industrial each rallied about 2%. 

Mike Loewengart, head of model portfolio construction at Morgan Stanley’s Global Investment Office, called the Tuesday market response a sigh of relief from investors, but suggested there’s still more work to do for policymakers. 

“If inflation is able to continue on this trend, the conversation around a soft landing will only get louder, but keep in mind inflation is still well-above the Fed’s target rate,” Loewengart wrote Tuesday in an email. 

Meanwhile, Morgan Stanley’s Mike Wilson highlighted Monday that investors should shift their attention away from inflation data and Fed rate hikes. Instead, it will be downward earnings revisions that drag on stocks the most for next year, he explained.

“We believe costs will remain elevated and prices received by companies will fall, creating negative operating leverage and a very challenging environment for earnings,” Wilson said.

But because it’s higher interest rates that underpin weaker earnings revisions, the chance of lighter-than-expected rate increases alleviates that earnings pressure.

Long story short, cooling inflation opens up the chance for moderating Fed policy, and negativity that’s been priced into markets alleviates — and stocks get their best-case scenario. 

Read the original article on Business Insider