Inflation Slows Once Again, but Trade Wars Pose a Threat

Stock market sentiment continues to be heavily influenced by developments in U.S. trade policy, particularly tariffs. Still, despite ongoing trade tensions and economic uncertainty, the S&P 500 remains just 3.8% below its all-time closing high reached on February 19.

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While tariffs are undeniably a key factor, some market observers are now turning their attention to other elements that could drive market performance in the months ahead.

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Veteran Wall Street strategist Jim Paulsen, who recently retired after four decades in the industry, shared his insights in a new blog post on Paulsen Perspectives. He identifies five fundamental factors that could lend considerable support to the stock market moving forward.

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According to his analysis, these elements include the federal funds rate, the yield on the 10-year U.S. Treasury note, the rate of inflation measured by the Consumer Price Index (CPI), the annual growth in the M2 money supply, and overall consumer confidence in the U.S. economy.

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Drawing on data from the 1960s onward, Paulsen analyzed how the S&P 500 has historically performed under various combinations of these conditions. For instance, he notes that when the M2 money supply shows annual growth, the stock market tends to respond positively. Specifically, during periods when M2 expanded, the S&P 500 delivered an average annualized return of 12.7%. In contrast, when the money supply growth slowed, the market only managed an average gain of 2.2%.

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The data paints a similar picture for changes in interest rates. Paulsen found that when the Federal Reserve cut the federal funds rate, the S&P 500's average annualized gain was 10.5% higher than when rates were increased. Additionally, lower long-term bond yields, moderating inflation, and growing consumer confidence each had a history of bolstering stock prices on their own.

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When all five of these factors align positively, the effect is even more powerful. According to Paulsen’s analysis, when all five support pillars are active at the same time, the average annualized gain for the S&P 500 since 1960 jumps to 16.3%.

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So where do things currently stand with these five market drivers? Paulsen believes that while not all are currently providing full support, several are poised to become more favorable in the coming months.

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First, monetary policy has been restrictive for most of the current bull market. Unlike past bull runs that benefited from falling interest rates and a growing money supply, the current rally started in October 2022 while the Fed was still tightening monetary policy. Since then, M2 money supply has grown at a sluggish 0.8% annualized rate. Adjusted for inflation, the real M2 supply has actually been shrinking at an annual pace of 2.2%, in part due to the Federal Reserve’s efforts to reduce its balance sheet.

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Paulsen notes that this lack of monetary support has been a key differentiator for this bull market. The bond market hasn’t been much help either. The 10-year Treasury yield was around 4.25% when the rally began and has largely stayed within a range of 3.5% to 4.75%, denying investors the benefits of a consistent downward trend in long-term rates.

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Of the five support factors, inflation has been the most helpful so far. Since the start of the bull market, CPI has dropped from 7.75% to just 2.3%. While recent tariffs could create inflationary pressures, Paulsen expects inflation to remain mostly stable or potentially decrease slightly over the coming year, rather than spiral out of control.

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Consumer confidence, another key pillar, has remained relatively low in recent months. However, recent data suggests that sentiment may be on the rebound, signaling the potential for this factor to shift into a more supportive role.

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Paulsen acknowledges that skeptics may view the current market as overvalued or nearing the end of its run. However, he contends that if inflation stays contained and economic growth remains modest, the environment could become more favorable for equities. Under such a scenario, the five market drivers he highlights are likely to turn increasingly positive.

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In his closing thoughts, Paulsen advises investors to remain in the market for now. He believes that the full set of market supports has not yet been exhausted and that exiting prematurely could mean missing out on further gains.

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Meanwhile, U.S. stock-index futures were slightly lower, with Treasury yields holding steady. The dollar strengthened, oil prices edged higher, and gold hovered around $3,297 per ounce, indicating a cautious but watchful mood in the broader financial markets.

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