Can U.S. stocks extend the bounce? Inflation worries linger ahead of key jobs data.

Investors took a breather this week as U.S. stocks bounced back from a weeks long selloff and the latest reading on inflation offered glimmers of optimism to those hoping for a peak in price pressures.

Beneath the surface though, strong undercurrents of worry about inflation remain . April’s reading on the Federal Reserve’s preferred gauge showed inflation slowing, but it wasn’t enough on its own to settle the debate on where price rises go from here. And stocks can typically bounce, even when they’re already in or headed toward a bear market, said Wayne Wicker, chief investment officer of Washington-based MissionSquare Retirement, which oversees $33 billion.

With the S&P 500 index and Nasdaq breaking a streak of seven straight weekly declines and the Dow Jones Industrial Average
ending a stretch of eight consecutive weekly declines on Friday, it might be easy to look past the recent volatility that gripped financial markets since mid-May.

See: Why the Dow finally bounced — and what it will take to convince investors it’s for real

However, history shows that inflation can linger long after the Federal Reserve has started hiking interest rates. Consumer sentiment is currently mired at a 10-year low, while falling corporate profit margins are another threat facing the S&P 500
says Capital Economics’ John Higgins, who sees the index bottoming at 3,750 from Friday’s closing level near 4,158.

The ability of a single company like Target Corp.
or Snap Inc.
to issue a missed-profit announcement or warning that triggers wider stock selloffs signaled a distinct shift in the market’s thinking toward the insidiousness of inflation, and may render parts of next week’s nonfarm payrolls report stale.

Portfolio manager Scott Ruesterholz at Insight Investment, which manages $1.1 trillion in assets, points to the number of technology companies that have announced layoffs or hiring freezes since May 12, plus the additional businesses that have seen staffing pressures ease, which may not show up in official data for months.

“The volatility stemming from individual companies’ announcements is the largest since 1987,” Ruesterholz said via phone. “The reason why there are such outsized moves is that we have very little confidence around the inflation outlook.”

“Often times, the jobs market tends to lag turns in the economy and that’s particularly true in periods of significant volatility,” said the New York-based portfolio manager, who thinks tightness in the U.S. labor market has peaked. “There will be a little less significance seen in the jobs data, particularly if the number comes in strong, because you will wonder if that’s still the case today.”

Ruesterholz said he expects payroll growth to fall to 275,000 in May from 428,000 in the prior month, which is below the consensus estimate for a gains of 325,000 jobs in a survey of economists by The Wall Street Journal. The data will be published next Friday. In addition, he says, the “market will probably brush off the payroll number,” while taking into greater consideration the reading on average hourly earnings, which he expects to moderate.

Contributing to this week’s stock rebound was the sense among many investors that Fed policy makers might need to back off from aggressive interest rate hikes by year-end, given the likely impact on economic growth. Traders have pulled back on their expectations for how high the main policy rate target can get in 2022.

“This concept that the Fed is going to back off for some reason is completely misguided,” said Thomas Simons, a money markets economist at Jefferies. “The Fed is much more focused on inflation and less concerned about deflating the financial market going forward.”

With fixings traders projecting five more 8%-plus annual headline readings in the consumer-price index from May to September, one question is whether consumers will be able to weather further increases in inflation and continue to prop up growth for the rest of this year and 2023, Simons told MarketWatch. 

Meanwhile, “negative sentiment is going to be at play for a while,” Simons said. “Financial assets are going to look very, very cheap at some point and I think there will be some support for stocks even in a period where markets go sideways.”

Despite this week’s rebound in U.S. stocks, the Nasdaq Composite
remains firmly in a bear market, off by more than 20% from its peak, while the S&P 500 briefly flirted with one. This is the case even after just two Fed rate increases that have left the fed-funds rate target between 0.75% and 1%. Traders see a better-than-50% chance that the central bank will lift the fed-funds rate target to between 2.5% and 2.75% by December, while policy makers have acknowledged they’re likely to deliver a few more hikes.

Friday’s reading on the Fed’s preferred inflation gauge, known as the personal-consumption expenditures price index, showed price pressures easing in April. The rate of inflation over the past year slowed to 6.3% last month from a 40-year high of 6.6% in March, the first decline in a year and a half. However, investors have seen a “head fake” before, when one seemingly soft inflation number overshadowed the bigger dynamic of still rapidly rising costs.

Recent financial market volatility offers some guidance as to how quickly investors are willing to brush aside even positive economic data in a higher inflation environment. A case in point was April’s retail sales figures, released on May 17, which climbed a 0.9% and gave many investors reason to think the economy still had vigor. Stock investors cheered the news that day, only to see Dow industrials skid almost 1,200 points on May 18, while booking its worst daily plunge in about two years, as stagflation fears took hold and higher costs eroded retailers’ quarterly profits.

However, most of the move down in stock values “can be entirely explained by multiples going down, not earnings going down,” said Ed Al-Hussainy, a New York-based senior interest rate and currency analyst at Columbia Threadneedle Investments, which managed $699 billion as of March.

Related: Here’s the real reason the stock market is coming unglued — and it isn’t because of weak earnings

In the past 20 years, more than half of the S&P 500’s strongest days have taken place during bear markets, according to Wicker of MissionSquare Retirement. “So it’s entirely possible, even after a week like this that’s moving us to the upside, to see greater volatility which could take markets lower in the months ahead,” he said.
“Next week’s labor market data really takes a back seat to people’s focus on Federal Reserve meetings and where inflation rates are headed at the moment.”

May’s nonfarm payrolls report, to be released on June 3, is the highlight of the holiday-shortened week ahead. U.S. financial markets, including the New York Stock Exchange, will be closed on Monday for Memorial Day.

If there’s an upside surprise to job gains, plus a larger-than-expected drop in unemployment from April’s level of 3.6%, “that strengthens the argument for rapid tightening of monetary policy that keeps the Fed on track for a 50 basis point hike each in June and July,” said Bill Adams, the Toledo, Ohio-based chief economist for Comerica Bank. And if the pace of job gains persists between now and the next few months, policy makers could hike again by a half-point in September, he said.

By contrast, a big miss would entail “less urgency to get interest rates back above 2% or 3%” — suggesting a pause or scaling back on the size of moves, Adams said via phone.

U.S. data releases on Tuesday include the March S&P CoreLogic Case-Shiller national home price index, the May Chicago purchasing managers index, and the May consumer confidence index from the Conference Board. The next day brings the final reading of the S&P Global U.S. manufacturing PMI for May, the ISM manufacturing index, and the Fed’s beige book report, as well as April data on job openings, quits, and construction spending.

Thursday’s data releases include Automatic Data Processing’s private sector employment report for May, weekly initial jobless claims, and revisions to first-quarter productivity and unit labor costs.

Friday brings May data on the U.S. unemployment rate from the Labor Department, average hourly earnings, labor-force participation, the S&P Global U.S. service sector PMI for May, and the ISM services index.