The stock market this year has largely been in a state of uncertainty. That's because inflation has run rampant, and the economic outlook has gotten more and more negative to the point where most investors are now expecting some kind of recession next year or in 2024.
After four consecutive jumbo 0.75 percentage point interest rate hikes, the Federal Reserve finally seems to be making some headway in its war with inflation, although how persistent inflation might be is still a bit of a mystery.
Tomorrow, the market will get more insight into how inflation is trending, which could also impact investors' broader view of the economy heading into 2023. It could be a huge day for stocks. Let me explain.
A mild or severe recession
At this point, I think the majority of market participants are expecting a recession at some point in the near future. The bigger question is whether or not there will be a mild or severe recession. The market could probably handle a mild recession, and it may actually help bring down sky-high consumer prices.
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Last month, the market reacted very positively when the Consumer Price Index (CPI), which tracks the prices on a market basket of goods and services, only rose 0.4% in October from September and was only up 7.7% year over year. Inflation was still high, but the CPI came in much weaker than economists had been expecting.
Still, it has been difficult this year to get two CPI reports in a row to show that inflation is easing. Other conflicting data has also muddied the waters. For instance, on Friday new data from the Producer Price Index, which measures how much companies receive for items they sell and is a good indicator of wholesale inflation, rose more than expected on a monthly basis, although it still seems to be trending downward year over year. Tomorrow, all eyes will once again be on the November CPI report, which will be released at 8:30 a.m. EST.
Why the labor market is so important
There was also another somewhat conflicting data point at the beginning of this month. The November jobs report came in much stronger than expected, with the economy adding 263,000 jobs and the unemployment rate remaining unchanged at 3.7%.
I found this particularly interesting because Fed Chairman Jerome Powell has previously said he needs to see some deterioration in the labor market for the Fed to know that inflation is easing. While a strong labor market can be great for the economy, it's actually been driving inflation this year because it's created a strong consumer who is spending heavily.
But a likely best-case scenario for the economy next year is if inflation can cool while unemployment only rises modestly. Tomorrow, if the CPI once again shows evidence that inflation has peaked and is headed downward, that might make investors more optimistic about a mild recession and a softer landing for the economy. Of course, the labor market is often a lagging indicator, and I do not think we've felt the full effect of all of the Fed's rate hikes yet.
The Fed's final meeting of the year also starts tomorrow, meaning the fresh CPI report will likely be the last piece of data they see before announcing their final rate hike of the year. While the bulk of investors are expecting a minor pivot to a half-point rate hike on Wednesday, it's certainly not unanimous.
According to CME Group's FedWatch Tool, which looks at future pricing data for the federal funds rate, the market still sees a little less than a 25% chance that the Fed will continue with a 0.75 percentage point hike on Wednesday. If this happens, it would clearly be devastating to the market, but a good CPI report would also likely make more people expect a half-point rate hike.
How to think about tomorrow
Nowcasting, a service sponsored by the Federal Reserve Bank of Cleveland which makes projections regarding inflation, projects that the CPI in November rose by 0.47% from October, which would likely be perceived as disappointing because the CPI rose 0.4% on a monthly basis in October. Nowcasting expects the CPI in November to be up by about 7.5% in year-over-year terms, which would be an improvement from October.
If CPI numbers come in under these projections, I would expect the market to perform well tomorrow because it would show that inflation is continuing to slow. Keep in mind that if the numbers come in much lower, investors might get concerned that demand is drying up too quickly. And then of course, if the numbers come in higher than expected, that might concern investors about persistent inflation and more rate hikes from the Fed, which would likely send stocks lower.
However, I would caution investors from trying to time the market. One can never truly know how investors will react. The best approach is to continue to invest in stocks with strong fundamentals and a good long-term outlook. Those will be winners regardless of short-term volatility.
