US inflation continued to moderate in May, which has helped equity markets push on to new highs. Should the progress on inflation continue, we could see more investors putting cash to work, but there are cautions to consider.

US inflation has dominated investor mindset since its rise following the COVID-19 pandemic. The pace of inflation peaked in 2022 and has had a bumpy ride lower since then. The key drivers for the disinflation trend have been the reopening of supply chains which has boosted supply, and global interest rate hikes which have helped slow demand.

Notable drivers of rising core inflation were surging used cars prices, cost of leisure and hospitality services, and shelter (home prices and rents). However, the descent from this inflationary peak has been underway, and the April US CPI report brought a sigh of relief, with Bloomberg showing core inflation falling to 3.6% year-over-year, the lowest reading in three years. Services prices, which had remained stubbornly high, eased in April, while goods prices continued their decline, aided by falling auto and home-furnishing costs.

In the commodity markets, oil prices, which peaked above $US120 per barrel in 2022 amid the global economic reopening and the Russia-Ukraine war, have failed to respond dramatically to recent Middle East tensions, currently sitting more than 35% below that peak. Meanwhile, gold reached a new peak above $US2,400 in mid-May, potentially driven by demand from central banks.

Clear air but beware turbulence

While the overall trajectory of inflation is encouraging, the path ahead is not without obstacles. Shelter prices, a persistent thorn in the side of disinflation efforts, have moderated only gradually. Timely data on rents suggests that more relief may be on the horizon, but the pace of this relief will be crucial. Additionally, the low-hanging fruit of disinflation from improving supply chains has largely been realised, and goods prices, while still in decline, may provide less assistance moving forward.

On the other side of the financial landscape, the stock market has been scaling new heights. The post-pandemic peak came just days into 2022, fuelled by stimulus and economic reopening. However, this party was short-lived, as US Federal Reserve rate hikes aimed at taming inflation sent stocks tumbling more than 25% by October 2022. The new bull market that emerged in October 2022 has not been without setbacks, but the S&P 500 has rallied nearly 52% since then. While the technology sector and enthusiasm around AI have been driving forces behind this ascent, leadership has begun to broaden more recently. In US markets, cyclical areas like industrials and financials, as well as defensive and rate-sensitive sectors like utilities, have taken the lead in recent weeks, a positive sign for the longevity of this bull market.

What lies ahead?

US Corporate earnings growth is expected to reach new highs in 2024, aided by ongoing economic growth and the potential for lower interest rates in the coming years.

The path ahead for stocks will continue to be guided by expectations for upcoming US Federal Reserve policy moves. The April US CPI report was pivotal in preserving hope for a rate cut this year, but volatility may persist as the market grapples with the exact timing of such a move. However, another peak that could provide horsepower for this bull market is corporate earnings growth. With profits expected to reach new highs this year, aided by ongoing economic growth and less punitive interest rates, the growth in earnings could set the pace for equity market gains ahead.

Milestones like the Dow Jones Index briefly eclipsing 40,000 last week are more symbolic than significant. However, they represent the substantial rally in stock prices over the past few months and years, defying economic and Fed policy risks, as well as the allure of elevated return on term deposits and savings accounts.

Conclusion

History shows that after surpassing previous peaks, stocks have, in most cases, gone on to log strong gains. As we navigate these peaks, it’s crucial to maintain a long-term perspective and an opportunistic investment approach. The financial landscape is ever-changing, but by understanding the dynamics of inflation, stock market performance, and their interplay, investors can chart a course towards sustainable prosperity.

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