As U.S. inflation continues to cool, stocks are riding a wave of optimism.
Some bulls expect an improved economic outlook to send the S&P 500 to an all-time high later this year. The large-cap equities gauge hit a record close of 4,796.56 in January, 2022, according to Dow Jones market data.
In that camp stands Scott Ladner, chief investment officer at Horizon Investments. “This is increasingly looking like an economy that just can’t get knocked off its footing,” said Ladner in a phone interview.
“We see the nominal GDP coming in the 5% to 7% range this year. And earnings are priced at 0% right now. So we think there’s some room for earnings to catch up,” Ladner said.
Meanwhile, the Federal Reserve may be be close to the end of its year-long campaign to raise interest rates to slow the economy and lower inflation and steady or lower borrowing costs add more fuel to the rally, noted Ladner.
The market consensus is that the Fed will raise its interest rate at least one more time before the year concludes. Future funds traders are pricing in an over 95% chance the U.S. central bank will raise its bench mark interest rate in July by 25 basis points to the range of 5.25% to 5.5% and a 23% likelihood that it will deliver one more hike after July, according to CME Fed Watch.
“We might have already seen the peak of interest rates. That’s actually some fuel for multiples to be able to expand,” said Ladner.
Greg Bassuk, chief executive at AXS Investments, echoed the point. “While we do anticipate at least one more rate hike, we think the ending of a two-year track of rate hikes is going to put more certainty into the market and very importantly, have the U.S. economy achieve a soft landing and avoid a recession.”
Adding to the tailwind for risky assets is a weakening U.S. dollar. The ICE U.S. Dollar Index
DXY,
+0.03%
fell to 99.96 as of 4 pm Eastern on Friday, the lowest close since April 2022, according to Dow Jones market data.
If the Fed is close to being done with increasing its benchmark interest rate, while other central banks are not, it would weigh on the greenback even further, noted Ladner.
Dangers lurking
Still, there are several challenges that may impede stocks from extending their rally.
Raymond Bridges, portfolio manager of the Bridges Capital Tactical ETF
BDGS,
-0.10%,
said he expects U.S. stocks to end the year lower, citing further tightening of credit conditions.
Read: The U.S. stock-market rally seems unstoppable, so why does bearishness still persist
The Fed’s balance sheet has been shrinking for the past few months, after the central bank again expanded it in March by setting up a new emergency loan program and lending more than $300 billion to provide liquidity when some regional banks failed during the first quarter of the year.
“Those bank term funding programs added a lot of liquidity into the marketplace to stave off a recession, or a credit crunch,” Bridges said. “It was a nice lifeline [for banks], but I think that’s what extended this bear market rally that we’ve had.”
As the Fed’s balance sheet declines to levels seen before March, some banks will have to pay back the emergency loans to the Fed which have a tenor of up to a year, “that’s actually a net liquidity draw,” according to Bridges.
“I see all of that occurring as well as another rate increase. We’re gonna need something to change policy-wise and some blow-out earnings to get a continuation in the [upward] trend in stocks,” Bridges said.
What’s more, if the Fed ends up delivering more interest rate hikes after July, it could significantly undermine the U.S. economy. The Fed’s dot-plot forecast in June showed that officials expected two more rate hikes by the end of the year.
Also read: Fed’s Waller, unimpressed by inflation data, calls for two more rate hikes this year
Philip Colmar, managing partner and global strategist at MRB Partners, said while he doesn’t think the credit conditions are tight enough for a recession to hit this year, if the Fed “is forced to do more than another 25 basis point hike before it pauses or if yields were to move meaningfully higher, then maybe we’re getting that catalyst [for a recession] in place.”
Check out: Why markets are misjudging the Fed’s ability to raise rates even though inflation is slowing
Analysts at Capital Economics are even more bearish, saying the U.S. economy is already heading into a mild recession.
“While we do think AI is a transformative technology that will give rise to a much stronger stock market in 2024 and 2025 as investors seek to crystallise its benefits upfront, we are sticking to our forecast that the S&P 500 will drop back a bit in H2 2023 as the US economy flags in the meantime,” John Higgins, Capital Economics’ chief markets economist, wrote in a recent note.
What’s more, while many analysts expect inflation to continue head downward, there might be bumps in the road, with prices rising more than expected for certain months, noted AXS’s Bassuk.
“A lot of factors contribute to the CPI, the PPI. And all it takes is a slight change in any one of these months,” Bassuk said.
U.S. stocks ended the past week higher, with the Dow Jones Industrial Average
DJIA,
+0.33%
up 2.3%. The S&P 500
SPX,
-0.10%
gained 2.4% and the Nasdaq Composite
COMP,
-0.18%
finished the week 3.3% higher.
For the coming week, investors will be expecting U.S. retail sales data on Tuesday, housing starts numbers on Wednesday, and initial jobless claims data on Thursday.
