Stocks Face Inflation Risk in Market With Fewer Reasons to Rally

Weaker-than-forecast payrolls data Friday offered relief to equity investors betting on continued government support. Yet the report also points to a risk for a stock market that is running out of catalysts to move higher: A labor shortage that could add to inflationary pressures.

While the S&P 500 Index jumped to a record after the jobs data, some market players were quick to question whether the disappointing report will trigger enough stimulus to outweigh risks from rising inflation and eventual monetary tightening from the Federal Reserve. With frothy valuations after a massive rebound from last year’s selloff, there is growing concern about a lack of ingredients for further gains.

Losses in U.S. stocks on Monday were worst among once-high flying technology and Internet companies considered most-vulnerable to faster inflation and higher interest rates. The NYSE FANG+ Index plunged 3.5% to its lowest level since March. Traders bid up the price of hedges against further declines in the tech-heavy Nasdaq 100 Index, sending the Cboe NDX Volatility Index up 16% to an almost six-week high.

“Fiscal and monetary stimulus are all priced in, and even as the economy is reopening, there is a rising wall of negative catalysts on the horizon,” said Matt Maley, chief market strategist at Miller Tabak + Co. “If you combine a view that the Fed could see a weak jobs report as a one-time setback, with interest rates moving higher and growth being priced in, all of a sudden that gives us less of a cushion than we’ve had.”

Treasury bears viewed the jobs report as an indication that companies will need to lift wages to entice people back into the labor force -- a development that some believe could clear a path for 10-year yields to reach 2%. And bond market expectations for the pace of consumer price inflation over the coming half decade have surged to the highest level since 2006.

The 10-year yield rose two basis points to 1.59% on Monday. Tesla Inc. plunged 6.4%, while Facebook Inc., Netflix Inc. and Amazon.com Inc. each lost more than 3% and Apple Inc. and Microsoft Corp. fell more than 2.5%. Cathie Wood’s ARK Innovation ETF sank 5.2% to the lowest price since November.

Morgan Stanley strategists are warning investors that the labor shortage may weigh on the economic recovery that has been fueling the market rally. T. Rowe Price said it’s now underweight equities versus bonds in its multi-asset funds because valuations are getting stretched and the risk of a negative event sparking a selloff could increase.

“For many, the weak payroll number just means more accommodation from the Fed, or at least not a withdrawal any time soon,” Michael Wilson, an equity strategist at Morgan Stanley, wrote in a May 9 note. “From our vantage point, the equity risk premium is underpricing these cost/supply issues.”

That risk premium, or the extra compensation that investors seek to hold U.S. stocks rather than the safest assets, is sending a warning shot that the post-pandemic rally may be reaching its limits. The last time the spread between the S&P 500’s earnings yield and the 10-year Treasury rate was this low was more than a decade ago; based on forecast earnings, it hasn’t been this thin since 2007.

Stocks Face Inflation Risk in Market With Fewer Reasons to Rally

To be sure, many major asset managers remain bullish on equities over the longer term, as they struggle to find an alternative with bond yields remaining low. Neuberger Berman’s Erik Knutzen said his firm remains positive on risky assets on a 12- to 18-month horizon, but is more cautious about the next three to six months. Morgan Stanley recommends investors stay selective. Their strategists expect equities to reach new highs next year, but believe that will come after flat returns for this year -- including a correction of as much as 20%.

Goldman Sachs Group Inc. economists said that while the disappointing payrolls data means that the Fed is likely to hold off on tapering, they continue to expect officials to start scaling back stimulus early next year.

Following the disappointing jobs report, investors this week will focus on a wide range of U.S. data, including the Consumer Prices Index and retail sales. More clues about the strength of the economy and the outlook for inflation could color views on when the Fed will begin tapering its bond-market purchases and eventually lift its benchmark interest rate.

“You got a very rich market that needs to recalibrate to the fact that the Fed will talk about the taper. For now, it’s a discussion of a discussion, so to speak, but the markets need to come to grips with the fact that that’s going to happen,” said Quincy Krosby, chief market strategist at Prudential Financial Inc. “It doesn’t mean a selloff is imminent, but at this point, valuations are really rich and the markets will need to adjust.”

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