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The downside risks hidden in a ‘normal’ market pullback: Morning Brief

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Stocks surged back Wednesday, reclaiming a portion of the steep losses suffered Tuesday following the hotter-than-expected headline inflation print that morning. Small caps led the way, with the Russell 2000 (^RUT) gaining over 2% after suffering its worst day in years.

But the larger question for investors remains: Was Tuesday’s rout a one-off, or the start of something bigger?

The balance of evidence suggests this is a short-term pullback with fresh record highs coming in a few weeks — in other words, a buying opportunity.

And regardless of how the economic data lands over the next few weeks, it wouldn’t be unusual for the S&P 500 to have a pullback after a blistering 20% rally off October lows, especially with where we are on the calendar.

As Ryan Detrick, chief market strategist at Carson Group, noted on X, the next four weeks on the calendar haven’t been great historically during the fourth year of a presidential term.

And with the index having gained ground 14 of the last 15 weeks, a breather is to be expected.

“Seasonal weakness is normal,” Detrick wrote.

However, tail risks are real, downside risks are non-trivial, and the best playbooks are highly nuanced.

Broadly speaking, the narratives driving soft landing expectations recently haven’t changed appreciably.

As Chicago Federal Reserve President Austan Goolsbee said Wednesday, “let’s not get amped up when you get one month of CPI that was higher than what you expected it to be.”

Meanwhile earnings growth, the engine of any bull market, remains strong — and the growth isn’t limited to the Magnificent Seven, though they’re definitely helping.

Further, most inflation metrics are still trending down. Tuesday’s headline and core prints may have surprised expectations to the upside, but the year-over year trends in both readings are heading lower.

Looking at the reaction in fed fund futures, Tuesday’s inflation surprise only took about half of one 25-basis-point rate cut off the table.

But peering inside the CPI report and measuring some of the numbers on shorter time frames reveals a few trends keeping some investors up at night. So-called supercore inflation, which measures core services inflation after taking out housing, has turned up sharply.

This inflation measure, frequently mentioned by Fed Chair Powell, plummeted from an annual rate of 8% to 3% late last year, but is back up to 5.5%. “This isn’t good news for markets,” Alfonso Peccatiello, proprietor of The Macro Compass, said on X.

And if inflation does more broadly turn higher, it could bring back into focus the “no landing” scenario that shook investors and disrupted markets in mid-2023.

In the meantime, expectations of Fed cuts are driving the boat, and the timing of these cuts is far less important than the fact that investors believe the next move is lower.

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