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September 01, 2020 1:26pm
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Rally Gains Momentum On Soft PCE Data

PCE index

The S&P 500 (NYSE: SPY) extended its summer rally after softer-than-expected PCE price data. The data is the latest in a string of good news that will help lift the market into mid-summer. The caveat is that inflation remains high, the Fed is on track to hike rates again, and the earnings outlook is declining. This combination is not a solid foundation for the market to rally and may lead to a significant correction by the end of the summer. 

The PCE price index cooled more than expected to 0.1% compared to last month. That is 30 basis points more than expected and suggests the cooldown of inflation is real. The problem is that core inflation, the figure that matters most, remains hot at 0.3% month-to-month and 4.6% YOY. Both figures are down 0.1% from the prior read but as expected and trending within a tight range. The core, year-over-year comparison for the PCE price index has trended between 4.6% and 4.7% for 6 months and has yet to follow the headline figure significantly lower.

The FOMC: No Reprieve, Another Hike Still Expected

The FOMC is expected to hike rates by 25 basis points at the next meeting. That meeting is in late July and carries an 85% chance for a hike. That’s down slightly on the PCE news but not significantly, and the odds are high rates will remain at the new 525 to 550 basis points range until the end of the year. The odds of 2, 25 basis point hikes remain low despite the Feds' insistence it’s possible. 

The risk they face is that underlying strength and a market grown used to the “new normal” will continue to underpin inflation. The cost of goods, led by housing and automobiles, fell, but services like health care are rising, offsetting the difference. Wages also continue to be an issue and are trending above 4.5% YOY growth. This means the market may be mispricing the FOMC outlook; if hot inflation lingers through the summer, another hike to 550-575 bps will come by September. 

A factor playing into the inflationary picture is government spending. Government spending projects and stimulus packages dating back to the earliest days of COVID-19, including the Inflation Reduction Act, are still working their way through the economy. This is helping to underpin demand and pricing for basic materials and, ultimately, inflation.

The Outlook For Earnings Continues To Sour 

The most significant risk for the market is the outlook for earnings. The consensus estimates for Q2, Q3, and Q4 were trending lower but flattened at the end of Q1 reporting—however, the downtrend in earnings resumed over the last week bringing the consensus figures to new lows. There is evidence of revenue growth and margin improvement within the S&P 500 but many signs of weakness offset that. Nike (NYSE: NKE) is the latest to report a weak quarter marred by narrowing margins suggesting weak results across the apparel and retail industry. 

The S&P 500 advanced on the soft PCE figure but is heading toward a potential ceiling. The ceiling may be at the top of the range, at the current all-time high, and it may be reached within the next few weeks. That puts the market on track to hit a new high before the peak of the earnings reporting season, which sets it up for a fall. If the outlook for the 2nd half weakens, the S&P 500 will have difficulty reaching a new high. 

SPX stock chart

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