Is Inflation Good for Equities?

February 22, 2016

Is Inflation Good for Equities? Photo

Last week saw a continuation of the uptick in the stock market that began Friday of the week before. The S&P 500 Index is up approximately 5% from its recent low and is no longer in a correction. This rally comes while crude oil is hovering around $30 a barrel as talks of a coordinated production cut have done little to raise prices. It is highly unlikely Iran will abide by any production cut and will more likely raise production to regain market share. One fact to show the amount of supply in oil is that U.S. Crude oil supplies actually made a new high last week of 504.1 million barrels. This is the highest reading in 86 years. Watch for this supply indicator to decline before any lasting move higher in oil prices can occur.

The key piece of economic data was the January Consumer Price Index (CPI). The core CPI (excluding volatile energy and food prices) rose 0.3%, the most since August 2011, and followed a December increase of 0.2%. Inflation data still remains low and energy is holding down the headline CPI numbers, but, given the recent uptick in average hourly earnings, it is worth watching any trend for inflation closely.

Is rising inflation good? I think so, at least for the short term. The recent declines in stocks and the economic slowdown around the globe have been driven by deflationary fears. Negative interest rates in Japan have been the catalyst. If U.S. inflation picks up and the Fed remains on the sideline, this could be a big positive for equities. It does rely on two big "ifs," but it could cause stocks to move to new highs.

Keep a close eye on currency volatility. With global fears of deflation and a Fed still outwardly intent on increasing rates, currency markets could bear the brunt of the volatility over the next few months.

I still plan to sell rallies in equities. The S&P 500 Index will probably test key resistance level of 1,946 this week. I expect this level will hold. With regards to bonds, I prefer to be short U.S. Treasuries with maturities 10 years or longer at these levels, but I am more constructive on shorter maturity (less than 5 year) notes.

Tags: Monday Morning O'Malley | Oil | Inflation | S&P 500 | CPI | Interest Rates | Iran

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