New pressure on the Federal Reserve to intensify its fight against inflation in its grip on the still-resilient economy is forcing Wall Street experts to rethink the stock trading landscape.
After a worrisome report on consumer prices hit Tuesday, bond investors raised expectations that interest rates will rise above 5% and stay there. Two-year Treasury yields rose again, with bets on a rate cut by the end of the year just missing out – a change from the dovish wagers of just a few weeks ago.
The picture is not as clear in stocks, where bulls and bears are fighting over what’s more important: rising rates, or an economy that last month grew fast enough to create half a million new jobs. Tuesday’s trading reflected each side of the debate with the S&P 500 first rising, then jumping, then bouncing back as traders weighed still-high consumer prices against new economic and earnings data that signaled a serious slowdown.
Barclays Plc strategists expect an economic regime in which growth will remain stable at the same time that central banks tend to push restrictive policies longer, a scenario known as no-landing. The bank has raised its growth and inflation forecasts for the US.
“Market expectations seem to have moved from a hard landing, to a soft landing and now no landing – a regime of sustainable growth and higher inflation again – which somewhat supports equities,” said Barclays strategist Emmanuel Cau. “Today’s CPI data maintains the status quo in this regard.”
A five-week rally to start the year has faltered this month, although with the S&P 500 down less than 2%, it is hard to say the market has issued a decisive signal. Now, strategists who warmed to the stock in January suggest further gains will be harder to come by at the same time as they are less wary of major selloffs.
In anticipation of a more restrictive policy path, Morgan Stanley is neutral on US Treasuries from overweight and expects investors to cut short dollar positions as they retreat from the idea of an upcoming policy pivot.
“The market debate could be the sensitivity of the economic interest rate and whether the neutral rate should be higher than previously thought,” said the bank’s strategist.
Although not the rule, times when relatively high interest rates went hand in hand with strong income growth did not exist in the US. Profits in the S&P 500 rose in the second half of the 1990s, just as the Fed was nudging rates higher. And while the central bank’s efforts to normalize policy at the end of the last decade finally wiped out equities in the last quarter of 2018, corporate earnings have risen throughout President Donald Trump’s administration.
Fed officials took the latest inflation data as another signal that interest rates need to return to those levels to ensure inflation continues to fall. The outlook has stymied buyers for nearly a year, and prompted fresh warnings on Wall Street that the equity rally may not continue.
“The Fed has won every one of those battles over the last 18 months – every time the market has tried to price or discount the Fed’s rhetoric or its forecasts, the market has lost that battle, they’ve lost the game. Chicken,” said Brian Nick, chief investment strategist at Nuveen. .
The higher the longer
Still, worries about a recession – although all but assured when the year began – have subsided. In the latest survey of fund managers from Bank of America, investors are less pessimistic about the economy than they were a few months ago. Only 24% of respondents expected a recession, compared to 77% in November and the number of investors expecting a rate cut in the next 12 months was the highest since March 2020.
“Tail risk is the biggest [is] still “higher for again” inflation,” according to the results of the survey.
This is because the chances of the US economy avoiding a recession also indicate that the Fed will find it difficult to cut rates.
“China’s reopening, lower European gas prices and strong US job growth have reduced the likelihood of a recession in the near term. This should also make core inflation more persistent, but pave the way for additional rate hikes,” the macro team wrote in Barclays in this week’s report.
All this puts a brake on the rally of continuous risk. Goldman Sachs strategists are neutral on equities for the next three months as macroeconomic conditions improve and downside risks diminish, but he warned that the market’s risk appetite “is ahead of the data.”
Christopher Harvey, chief equity strategist at Wells Fargo, sees a peak policy rate of 5% or lower than the current Fed swaps, but that may not lead to a sustained recovery. However, he said his bear market days are behind him.
“We see inflation moving stubbornly low, and the economy is more resistant than expected, with Fed Funds closing at 5%,” said Harvey. “It’s not a good or terrible environment for equities.”
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