Stock traders grab the inflation signal they needed for a rally

(Bloomberg) – Stock investors are starting to see a glimmer of hope as signs of spike in inflation appear.

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A once wide gap between consumer and producer price inflation has narrowed significantly since March. That should ease fears of runaway inflation, as it will help US companies improve their profit margins – and potentially push US stock prices higher again.

US producer price growth slowed in October, the latest sign that strong inflationary pressures are starting to ease. Stocks rose on Tuesday as data revived hopes that inflation is approaching a peak. This follows last week’s colder-than-expected consumer price reading, which triggered the largest daily CPI gain on record for the S&P 500, according to Bloomberg Intelligence data dating back two decades.

If producer prices continue to fall in the coming months, this could help support corporate earnings and, therefore, US equities, as a further deceleration in inflation would dissipate some of the urgency of the crisis. Federal Reserve to extend giant rate hikes beyond this year, according to Gillian Wolff, senior associate analyst at Bloomberg Intelligence. Ideally, it would also help loosen constraints on stock prices, she added.

“The CPI has to be higher than the PPI to alleviate some of the pressure on corporate margins in the near term, and that still hasn’t happened,” Wolff explained. “This tells us that the costs of inputs for businesses continue to rise globally faster than the costs of the consumer goods they sell.”

In the decade before the Covid-19 pandemic, the 12-month forward operating margins of S&P 500 companies generally rose in line with consumer prices. But closer examination shows that the moves were more positively correlated with the gap between the consumer and producer price indices than with the CPI alone, according to BI.

This gap is currently negative, with production costs rising faster than the prices companies charge consumers. But it has narrowed considerably, from minus 3.4% in September 2021 to minus 0.3% last month, a big improvement from the summer when the gauge was in the low single digits.

Negative spreads historically indicate lower stock returns, while flat or higher spreads generally mean bigger gains for stocks. The average monthly growth in S&P 500 margins over the past three decades is 1.4%, according to BI.

In the years since the CPI-PPI gap fell below zero, index spreads have only increased by 1.1% on average, compared to 4.2% when it was above zero. above this threshold. On average, a year after the CPI-PPI spread fell below zero, index returns were half as strong as when the spread was at least stable, according to BI data.

“August to October was the same pattern: close to zero on the spread, but still not able to turn positive,” Wolff said. “If the spread continues to improve, it’s definitely going in the right direction, but ideally it should be positive.”

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