What Hot Inflation and Delayed Rate Cuts Mean for Investors

Inflation is running hot and the Federal Reserve may not be cutting rates as much as expected, which could cause near-term trouble for the stock and bond market. However, there are reasons for investors to feel constructive about the longer-term outlook for their portfolios.

“It’s not the end of the world or the end of the bull market,” says Adam Turnquist, chief technical strategist at LPL Financial. Strong economic fundamentals and earnings results can drive stocks higher, and a pause in the equity market’s relentless rally could give frothy valuations a much-needed opportunity for a reset. For bond investors, higher rates mean more income. Overall, pockets of opportunity remain for investors who can stomach short-term volatility.

Strong Inflation Data Dented Stock and Bond Markets

Investors were blindsided on Wednesday when the Bureau of Labor Statistics reported that inflation as measured by the Consumer Price Index report rose at a stronger-than-expected 3.5% on an annual basis in March.

In response, expectations for Fed interest rate cuts were scaled back dramatically. Investors now see a 20.5% chance of a rate cut in June, compared with a 59.1% chance a week ago, according to the CME FedWatch Tool. At the same time, the Fed is expected to cut rates just two times in 2024, down significantly from the five rate cuts predicted at the start of the year.

The CPI report sent the Morningstar US Market Index down 1% on Wednesday. In the fixed income market, the yield on the 10-year Treasury note climbed nearly 20 basis points to 4.55% as the Morningstar US Core Bond Index lost 1.1%.

“We’re back to a regime where higher interest rates will likely pressure markets,” says Jeff Schulze, head of economic and market strategy at ClearBridge Investments. He thinks stocks trading at elevated valuations will “give investors a little more pause.”

Markets Remain Resilient Thanks to Strong Economy

Schulze points out that a resilient economy, including robust job numbers and consumers continuing to spend, has helped stocks climb higher since the Fed‘s last interest rate hike in July, even though rate cut expectations have been continually delayed. “That’s allowed investors in the market to shrug off this inflation,” Turnquist says.

An overbought market—where stocks trade at higher prices than their fundamentals can support—could dent returns in the short term, but the longer-term picture is rosier.

The market “needs a refresh and a digestion period,” Schulze says. “We don’t believe the digestion period will be more than a 5% or 10% pullback that may last a couple of months to a quarter. We think this is a pause in the expanding bull market.”

Pressure on valuations could also begin to ease. A landscape with fewer rate cuts “will likely act as a headwind to further rises in the valuation of stocks,” Dan Kemp, Morningstar’s global chief research and investment officer, wrote last week. He added that it may take a while to see the impact of that change.

Investors Can Find Opportunities Despite High Valuations

While the market remains relatively expensive, Erik Knutzen, chief investment officer of the multi-asset class at Neuberger Berman, says some areas of the equities landscape look more attractive based on how they’re pricing in inflation risk. “Higher rates put more pressure on more overvalued parts of the market,” he says. “At the index level, nothing’s cheap. But you go below the index, there’s haves and have-nots.”

While mega-cap tech companies like the Magnificent Seven are fully priced for a perfect economic environment, Knutzen adds, valuations for smaller and medium-sized companies and cyclical sectors like energy, utilities, and materials look more attractive. A strong earnings landscape also means he’s less concerned about high valuations overall.

“You’ve been seeing this rotation into areas of the market that have been lagging,” according to Schulze. “Our view is that broadening is a healthy dynamic. When more stocks are participating in the move higher, that increases the likelihood of the bull market continuing to chug along.”

Energy stocks in particular escaped the brunt of the market’s losses on Wednesday, with the Morningstar US Energy Index up 0.4% on the day. Analysts agree the sector is poised to outperform in a high-interest-rate environment. “It’s really the only sector positively correlated to yields,” Turnquist says. “It’s a nice portfolio hedge against inflation.”

Higher Rates Bring More Bond Market Income

Strategists say investors shouldn’t be surprised to see bond yields climb a little in the coming weeks as markets continue to recalibrate their rate expectations.

“The path of least resistance is still higher for the 10-year Treasury,” according to Schulze. But since rate cuts are still on the table this year, “Treasuries are probably not going to move materially higher from here,” he adds.

A “higher for longer” rate environment can also be a boon for fixed-income investors. “It provides a good opportunity to lock in higher income,” says Dan Close, head of municipals at Nuveen. “We finally have positive real yields.” He adds that if the Fed does indeed cut rates this year, investors can expect additional price appreciation from their bond holdings along with higher yields.

The Bottom Line for Investors

While Wednesday’s surprising inflation data certainly spooked investors, strategists warn against letting volatility caused by an uncertain economic outlook derail a long-term strategy.

“It’s critical to make sure your investment posture is consistent with a level of volatility that you can stomach,” says Knutzen, “because this probably is more of a buying opportunity in the short term.”

In other words, this temporary pullback in the stock market may be a positive for portfolios. “We’d be advocating for investors to take advantage of any weakness in equities,” Schulze says.

The same is true in bond markets. “Days like [Wednesday] provide opportunities to generate additional income if [investors are] willing to cost average in and continue to put money to work,” adds Close.