By Lewis Krauskopf
NEW YORK (Reuters) -A fresh look at inflation trends will test the U.S. stock market's rally in the coming week, with some investors saying equities are primed for a potential pullback after rocketing to records.
The benchmark S&P 500 was last up more than 7% on the year and within about 1% of its all-time closing high set in late July, as stocks largely rebounded from declines following a weak employment report earlier this month.
Strategists at firms including Deutsche Bank and
Morgan Stanley have recently said the market could be poised for some level of pullback after a largely unabated climb over the past four months, which has pushed valuations to historically expensive levels as a seasonally treacherous period for stocks begins.
The monthly U.S. consumer price index report, due on Tuesday, could cause volatility. Data showing higher-than-expected inflation could undermine the growing expectation for impending interest rate cuts.
"I do think the market is set up for a bit of a pullback," said Dominic Pappalardo, chief multi-asset strategist at Morningstar Wealth. "There's a lot of concern bubbling underneath."
The S&P 500 has soared well over 20% since its low for the year in April, as investor fears about a tariff-induced recession calmed after President Donald Trump's "Liberation Day" announcement earlier that month had set off extreme asset volatility.
The index is trading at 22.4 times its earnings estimates for the next year, well above its long-term average P/E ratio of 15.8 after recently reaching its highest valuation in over four years, according to LSEG Datastream.
Investors are also wary of risks posed by the calendar. Over the past 35 years, August and September have ranked as the worst-performing months for the S&P 500, according to the Stock Trader's Almanac. The index has declined an average of 0.6% in August and 0.8% in September -- the only months of negative average performance for the index during that time period.
"The combination of a softer payroll number with concerns of tariff-related inflation could be the recipe for ... a correction, especially in the seasonally weak third quarter," Morgan Stanley equity strategist Michael Wilson said in a note this week. Still, Wilson said his 12-month outlook was bullish, adding "we’re buyers of pullbacks."
The CPI for July is expected to have climbed 2.8% on an annual basis, according to a Reuters poll of economists. Investors will be watching to see if Trump's tariffs on imports are translating into higher prices after the June CPI report suggested levies were impacting the prices of some goods.
Market bets on Fed rate cuts rose following the recent weak jobs data as investors expect the central bank will ease monetary policy to help shore up the labor market. Fed funds futures indicate an over 90% chance the Fed will cut at its next meeting in September, with at least two cuts priced in for this year, LSEG data showed.
That narrative could be at risk if CPI rises more than expected, making the Fed more hesitant to cut rates, investors said.
"If the CPI suggests that the market got a little ahead of itself, that can create volatility," said Angelo Kourkafas, senior investment strategist at Edward Jones. "But if it's not worse than feared ... that can further reinforce that we are now in an inflection point for the Fed."
The prospect of higher tariffs and the economic fallout from those levies already instituted by the Trump administration has been a persistent theme clouding markets, but stocks have managed to rise to records despite the uncertainty.
Higher tariffs on imports from dozens of countries took effect on Thursday, raising the average U.S. import duty to its highest in a century, while the president also this week announced plans for levies on semiconductor chips and pharmaceutical imports.
China could face a potential tariff increase on Tuesday unless Trump approves an extension of a prior truce.
The impact of higher tariffs on the economy could take a while to show up, and "the market has kind of ignored the potential negative impact of this friction to the economy," said Matt Rowe, senior portfolio manager at Man Group.
"The market has gotten comfortable with tariffs being kind of a non-event, which I don't think is correct," Rowe said.
(Reporting by Lewis Krauskopf; Editing by Sandra Maler)
