Yesterday was a nasty day. But was it a one-off or a legitimate change in market perception?
With year-over-year inflation dropping to 3.1% instead of the expected 2.9%, is inflation reaccelerating? Is it just a blip and noise? Or could the surprise for the year be that the Federal Reserve doesn’t cut rates at all, or even worse, hike rates again?
Why the CPI Report Spooked Investors
Core inflation, which excludes volatile items such as food and energy, is often considered a more accurate measure of long-term inflation trends. Its increase points toward sustained price pressures that could challenge the market’s stability. But it’s hard to really know if this is a one-off data point or something that has longer-term implications.
Yes, the economy is strong, but there remains a ton of debt that needs to be refinanced into already-elevated rates. And we are still very much in the window of the lagged effects of the fastest rate hike cycle in history.
Small-cap stocks took yesterday’s reaction the hardest, but I don’t think it was justified at all. Despite volatility surging, credit spreads (the difference between junk and AAA) never really widened.
In other words, the bond market itself didn’t view what happened as being problematic. And while yields did rise, I’d argue it wasn’t commensurate with just how aggressively stocks fell. Sure, there is a possibility of another rate hike by the Fed, but it’s still a low probability. And so long as that’s the case, there’s still an argument to be made that hope pushes small-cap stocks higher in the short term.
Rate cuts by the Federal Reserve could serve as a mitigating factor for the risks faced by small-cap companies. By easing the cost of borrowing, the Fed can provide much-needed relief to these companies, thereby supporting economic growth and stability. This largely explains why small-caps outperformed strongly starting in mid-November of 2023, and why they’ve started to underperform this year as the Fed walks back its rate cut plans.
The Bottom Line
If the inflation data was a blip yesterday, then cuts are still coming, and even if they are less aggressive than initially hoped, there’s still reason for small-cap stocks to run as those refinancing concerns ease.
The relationship between inflation, market performance, and the role of small-cap stocks in the U.S. economy is intricate. I maintain my belief that small-cap stocks are due for relative strength here and think yesterday was an overreaction.
Having said that, my own signals point to a potential risk-off flip coming in March. There are a lot of people arguing to short stocks here, referencing weak seasonality in February. These concerns are valid, but one thing I know for sure is if something looks sure, you should be unsure about what happens next.
On the date of publication, Michael Gayed 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.
