Market Optimism Prevails as Investors Reconsider Impending Crash Theories Amidst Steady Gains and Low Inflation


Many investors are finding themselves at a crossroads, realizing that their predictions of an imminent stock market crash may have been premature or even incorrect. Despite contrary expectations from banks and investment houses, key equity markets have been steadily climbing throughout the year. While some may argue about specific details, such as the disproportionate impact of a few US tech stocks, the numbers speak for themselves: the S&P 500 has risen 18 percent this year, and the Nasdaq Composite has surged an astonishing 36 percent (yes, you read that right). Even Japan, a historically underperforming market, has seen an 18 percent increase, while several European indices have reached double-digit gains.

The most recent boost in optimism came from the release of US inflation data on Wednesday. The dark days of 9 percent inflation from just over a year ago are now distant memories, as the inflation rate dropped to a two-year low of 3 percent in June. This development has propelled the S&P 500 to its highest level in 15 months.

According to a banker I spoke with, hedge funds and other major investors were caught off guard by this turn of events. Consequently, not everyone has hopped on the bandwagon of this rally, leaving room for further upward movement, regardless of the pessimists’ desires. It’s a classic case of the “pain trade.”

“While our base case remains a recession,” said Wolf von Rotberg, an equity strategist at J Safra Sarasin in Zurich, “the recent inflation numbers make us consider alternative scenarios.”

The significance of the inflation numbers lies in the fact that if the market correction is indeed happening, the Federal Reserve can ease off on raising interest rates and even reverse their aggressive tightening without triggering the dreaded hard landing that fund managers have feared.

Looking at futures markets, it appears that investors anticipate one more quarter-point rate hike from the Fed in the autumn, followed by a series of substantial cuts over the next year and beyond.

However, it’s important to note that the futures markets might not necessarily reflect investors’ genuine beliefs about the Fed’s future actions. Tail-risk hedges, which involve large rate cuts to counter a severe recession, can easily distort the signal. Nevertheless, it’s difficult to argue against the current numbers.

Bob Prince, co-chief investment officer at Bridgewater Associates, one of the world’s largest hedge funds, is urging caution. He stated this week that “the Fed is not going to cut” and that market expectations of a rate cut are misguided. He has positioned himself for a tightening cycle. While he may have a valid point, being in that position is increasingly uncomfortable.

JPMorgan Asset Management shares the sentiment of skepticism. In its outlook for the remainder of 2023, it stated (just before the release of US inflation data) that the remarkable performance of risky markets this year is simply “too good to be true.”

The excessively positive state of stock markets and the relative strength of even the riskier end of the corporate bond market are causing unease. Hugh Gimber, a global markets strategist at the investment house, expressed his belief that markets are ill-prepared for the necessary slowdown to truly and durably control inflation. He suggested adopting a mentality similar to an armadillo, ready to quickly roll up into a shielded ball when a threat arises. “We are uncomfortable with the overly optimistic markets and believe it’s time to reduce exposure.”

While the rally in a small number of big tech stocks is currently propping up the market, Gimber added a cautionary note. During the Covid era, tech managed to evade the impact of a genuine recession. If a recession were to finally take hold, significant damage to the overall market could occur.

Von Rotberg at J Safra Sarasin echoed this point, noting that while buying tech stocks has been a successful defensive strategy lately, it’s the exception rather than the norm, and it “could revert back to the cyclical bucket.”

However, with the exception of the UK, which faces unattractive growth and inflation prospects, we find ourselves in an overall favorable position.

“We are in an amazing Goldilocks situation,” stated Fahad Kamal, chief investment officer at SG Kleinwort Hambros. “The economy is not in bad shape, employment rates are good, and consumers are feeling secure. Experiencing a 6 percent increase in pay has a greater psychological impact than paying 8 percent more at the store. As mammals, it’s a more visceral experience.”

Kamal also remarked that the decline in US inflation doesn’t feel alarming, to say the least. Moreover, earlier this year, during the short-lived US banking crisis, we witnessed the Federal Reserve’s willingness and ability to quell fires using its balance sheet. “We have all those elements in place, along with the comforting Fed backstop, just in case,” Kamal added. When viewed from this perspective, what’s not to like? Pessimists should brace themselves, as the pain trade could become even more agonizing.

Source: The Financial Times