By Lewis Krauskopf
NEW YORK (Reuters) - Wild swings in stocks and a sharp run-up in government bond yields are putting the spotlight on next week’s U.S. inflation data, as investors brace for more volatility across assets.
A turbulent week in markets ended with a surge in Treasury yields to their highest level in more than two years after surprisingly strong U.S. jobs data stoked expectations of a more hawkish Federal Reserve.
Robust data on inflation – which hit its highest annual level in nearly four decades in December – could further bolster the case for a more aggressive Fed and extend the climb in yields, dulling the allure of an equity market struggling to rebound from last month’s tumble.
Due out on Thursday, the U.S. consumer price index for January is expected to have risen 0.5%, culminating in an annual rise of 7.3%, which would be the largest such increase since 1982, according to a Reuters poll.
“We could potentially get a very difficult number to digest next week on the inflation front and that has the potential to cut the markets off at the knees,” said Jack Ablin, chief investment officer at Cresset Capital Management.
The yield on the benchmark 10-year U.S. Treasury note, which moves inversely to prices, has climbed about 40 basis points in 2022 to over 1.9% as investors factor in at least five rate increases from the Fed this year.
The climb has weighed on equities overall while contributing to steep declines in the shares of many tech and growth stocks, whose valuations rely on future profits that are discounted more steeply as bond yields rise. The benchmark S&P 500 is down about 5.6% so far to start the year, with the tech-heavy Nasdaq logging a nearly 10% drop.
“The reason why people are hitting the reset button ... is because valuations were pulled forward a lot," said King Lip, chief strategist at Baker Avenue Asset Management. "With rising rates, the valuations just can’t be justified. So whenever there is a little bit of a miss (on earnings) is when these stocks get punished quite a bit."
The forward price-to-earnings ratio for the S&P 500 has fallen to 19.5 times from 21.7 times at the end of 2021, while the forward P/E for the S&P 500 tech sector has dropped to 24.4 from 28.5, according to Refinitiv Datastream.
Some investors believe stocks have further to fall before they become attractive. Analysts at Morgan Stanley (NYSE:MS) on Friday urged clients to sell into equity rallies as “a tightening Fed historically brings lower returns and great uncertainty for equities” and wrote that the S&P 500’s fair value is closer to 4,000. The benchmark index on Friday rose around 0.5% to 4,500.
Others are questioning whether the growth stocks that have led the markets higher for years are ceding leadership to so-called value stocks, comparatively cheap stocks that are expected to do better in a rising rate or inflationary environment.
The S&P 500 value index, replete with shares of energy firms, financial companies and other economically sensitive names, had declined 1.4% so far this year as of Thursday, versus a 10.2% drop for its S&P 500 growth counterpart. That disparity would be close to value's biggest annual outperformance over growth in two decades.
"You are seeing gradually higher market interest rates that is causing investors to reassess and to look at near-term profitability and the value and cyclical trade," said John Lynch, chief investment officer for Comerica (NYSE:CMA) Wealth Management.
The market was also digesting a topsy-turvy week of high-profile earnings. Shares of Google parent Alphabet (NASDAQ:GOOGL) Inc and Amazon.com Inc (NASDAQ:AMZN) soared after their respective quarterly reports while megacap peer Meta Platforms Inc tumbled after the Facebook (NASDAQ:FB) owner's dour forecast.
Next week, reports are due from Walt Disney (NYSE:DIS) Co, Coca-Cola (NYSE:KO) and Twitter Inc (NYSE:TWTR), with Nvidia (NASDAQ:NVDA) Corp set to report the following week.
As with Meta Platforms, any disappointments in reports - especially from companies whose valuations remain expensive - could result in severe market fallout, investors said.
"It’s been a volatile start to the year with investors swinging between concerns over Federal Reserve tightening and confidence in the economic recovery," Art Hogan, chief market strategist at National Securities, said in a research note. "Meta aside, a solid earnings outlook is helping to ease the uncertainty, at least for the moment."