Stock market's soft-landing rally faces CPI inflation test. Here's what investors should do.

By Isabel Wang

Middle East tensions, the port strike, and the Fed's interest-rate outlook puts inflation front and center again for the U.S. stock market this week

The U.S. stock market celebrated the start of the Halloween season with treats.

A blockbuster September jobs report may have paved the way for the economy to score a soft landing as inflation has fallen, but it also forced investors to dial back bets on the Federal Reserve's future interest-rate cuts while pondering whether the central bank made a policy mistake by lowering interest rates by a half percentage point last month.

That has left Wall Street seeing this coming Thursday's consumer-price-index (CPI) report as the next key event for the U.S. stock market. A hotter-than-expected September CPI report and potential inflation resurgence in the coming months could further restrict the pace at which the Fed may lower policy rates and, more importantly, throw a wrench into the stock rally, said analysts.

Economists polled by the Wall Street Journal expect headline inflation to rise 0.1% for September, while core CPI, a more closely watched measure that strips out volatile food and energy costs, is forecasted to increase 0.2%. The 12-month headline CPI rate is expected to cool to 2.3%, from 2.5% in August, while the core number is forecasted to remain steady at 3.2% year over year in September.

"The risk to the markets is that the Fed is too aggressive in cutting rates because inflation hasn't been beaten yet," said Nancy Tengler, chief executive officer and chief investment officer at Laffer Tengler Investments. "We are seeing the same modest upward trend in core CPI each month, and that's not the kind of disinflation that we'd like to see across the economy."

In Tengler's view, housing costs, one of the most persistent drivers of inflation this year, remained high and could become even stickier as China has rolled out a massive monetary stimulus measure which drove up prices of energy and materials. Meanwhile, escalating Middle East tensions and a dockworkers' strike, albeit brief, last week have raised concerns about inflation resurfacing later this year, she told MarketWatch via phone on Friday.

See: Why inflation worries are starting to show up in this part of the market again

Prices of Brent crude oil (BRN00) on Friday posted their largest weekly climb in two years as tensions in the oil-rich Middle East continued to flare in the wake of Iran's missile attack on Israel earlier this week. In the U.S., the now-suspended port strike that affected ports from Maine to Texas also stoked fears of supply-chain disruptions.

These events occurred just a few days before a blowout September jobs report on Friday eased concerns that the labor market was slowing down and raised hopes the U.S. economy could achieve a soft landing - a relatively rare success story for the Fed in which inflation cools without triggering a recession. The U.S. added 254,000 jobs in September, far exceeding expectations, while the unemployment rate fell to 4.1% from 4.2% in August, according to the Bureau of Labor Statistics.

But a higher-than-expected 0.4% monthly increase in the average hourly earnings in the September jobs report, which when combined with the "eye-popping" port workers wage agreement, still reminds investors that inflation may yet be an issue for the Fed, said Steve Wyett, chief investment strategist at BOK Financial. "There are not enough port workers as compared to the size of the labor force to have a direct impact on overall wage levels, but it appears the progress to the Fed's 2% target might remain slow," he noted.

See: The U.S. port strike is over. This is what it means for transportation and shipping stocks.

However, some analysts suggest that rising energy costs and the potential fallout of the three-day port strike may only bring "short-term disruption" to the disinflationary trend and drive CPI higher "on a short-term basis," and it won't create "sustained inflation" in the U.S. economy, said Luke Tilley, chief economist at Wilmington Trust Investment Advisors.

Mary Ann Bartels, chief investment strategist at Sanctuary Wealth, also said investors should not worry about inflation resurfacing until oil prices return to $100 a barrel. MarketWatch reported on Friday some options traders are making bullish bets that oil could soon hit $100 a barrel on fears tensions between Israel and Iran could spark a wider regional conflict that threatens crude flows.

It's worth noting that financial-market investors will not see the impact of any of these "October surprises" in next week's September CPI report, but it might be "the last clean inflation data" before having some "cross currents" to deal with in the next few months, said Mike Reynolds, vice president of investment strategy at Glenmede Trust.

"If the CPI data starts to go in the wrong direction, that would really throw a wrench into the stock market and the economy, but we're not seeing signs of that yet," Reynolds told MarketWatch in a phone interview on Friday. "In an extreme scenario, maybe the Fed will start raising rates again... These are certainly not the base case, but that's something to be attentive to as a tail risk for stocks."

What's more, the third-quarter corporate earnings reporting season will kick into gear next week, with results from major financial firms such as JP Morgan Chase (JPM), Wells Fargo & Co. (WFC) and BlackRock Inc. (BLK), due on Friday, Oct. 11.

Earnings for the S&P 500's companies are expected to climb 4.6% for the third quarter from a year earlier, lower than the 7.8% growth rate projected in late-June following the downward revisions to earnings estimates by analysts and the negative earning-per-share guidance issued by companies, said John Butters, senior earnings analyst at FactSet.

Still, the 4.6% growth rate would mark the 5th straight quarter of year-over-year earnings growth for the large-cap benchmark index, Butters said in a Friday note.

But Tengler said the lower earnings growth estimates suggest there's room for "upside surprises" despite the rich valuations of some megacap technology stocks in a market near record highs.

"The stock market is due for a sharp pullback in October, and investors may want to buy it because we are in a bull market," she said. "... positive earnings and profit margins would be the surprise that will carry the market through the end of the year."

U.S. stocks rallied on Friday to eke out modest gains for the week. The S&P 500 SPX rose 0.2%, while the Dow Jones Industrial Average DJIA was up less than 0.1% and the Nasdaq Composite COMP advanced 0.1% last week, according to FactSet data.

-Isabel Wang

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10-06-24 1201ET

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