S&P 500: Cooling inflation and interest rate cuts pave the way for an optimistic final spurt until 2024

Summary and key findings:

• Inflation has eased and leading inflation indicators suggest that moderate figures can be expected for the remainder of 2024. Wage growth is also expected to continue to trend downward through the end of the year.
• This dynamic should allow the Fed to make one or two rate cuts in the coming quarters.
• Positioning, liquidity and financial conditions are relatively supportive of the equity market, but investors should be aware that there are still some immediate headwinds in the form of seasonality and near-term growth risks. Equity prices have aggressively priced in a recovery in economic growth.
• Overall, the equity market should be relatively well supported through year-end, with the possibility of a Fed rate cut and QT reduction amid a robust economy a recipe for a blow-off top.

Inflationary pressure remains subdued for the time being

Inflation, while high, continues to fall to levels of 2.5-3 percent. If we look at recent inflation trends in the context of leading indicators, the outlook on the inflation front remains relatively robust.

None of my key leading indicators point to significant upward pressure on inflation over the medium term, so I expect we will see relatively modest inflation numbers at least in the next quarter (and probably the rest of 2024), especially if wage growth moderates and the services/rent CPI trends lower.

Given the recent rise in property prices, CPI (Owners' Equivalent Rent) is likely to be the biggest concern, but I am not sure we are expecting any significant upward pressure from the OER front in the short term.

We will probably see some upward pressure from the consumer price index for goods and food soon, but at this point I suspect it will not be too great. While inflation is unlikely to return to 2% levels for a long time (if ever), the overall outlook remains relatively favorable for looser monetary policy in the short to medium term.

Even financial conditions (compared to the second derivative of the CPI below) suggest that the CPI's upward momentum will moderate over the next six months.

Employment and wages also speak in favor of a looser monetary policy

Similar to the inflation front, the labor market also continues to develop in the right direction from a monetary policy perspective.

Leading wage indicators unanimously point to a decline in wage growth for the remainder of 2024, a trend that is likely to translate into downward pressure on services inflation (particularly with regard to the consumer price index for rents).

Even though wage growth is bottoming out at a much higher level than in recent decades, the economic outlook on the wage side appears to continue to favour looser monetary policy, similar to inflation. In times like these, it is important to distinguish between cyclical and long-term trends.

On the employment side, as I have said for most of 2024, there is nothing to suggest an imminent rise in the unemployment rate. Leading indicators of job growth have all bottomed out and are rising, suggesting that job growth is likely to do the same.

Therefore, I continue to believe that concerns about an impending deterioration in the employment data to recession levels are overblown. I understand that unemployment is knee-jerk and could well continue to rise from here, but in a situation like this, I will always rely on the signals from leading indicators. It is also important to remember that much of the weakness we have seen in the employment data recently has been due to increased labor supply, not necessarily layoffs.

From a monetary policy perspective, this may be at odds with the dovish message that wage growth is sending, but I think it's fair to say that current employment data is at a level that does not require tighter monetary policy. The fact that employment growth is not expected to pick up significantly until later in 2024 also argues in favor of looser monetary policy.

Interest rate cuts are imminent

It's no secret that the Fed wants to cut interest rates. And as we've seen, both inflation and employment put the Fed in a position where it can easily get away with a rate cut or two in addition to curtailing its QT program.

The recent negative surprises in both inflation and economic growth support this assumption, as we can see below.

Similar trends are evident in both the Eurozone and Canada, suggesting that the global easing cycle is likely to continue for the time being.

Not surprisingly, the market has been quick to price in rate cuts again after the early August decline, which was partly due to the dollar-yen derailment. Rate traders now expect about four cuts in the next six months, with at least one in September. While I don't think there will be four cuts in the next six months, and I don't think there will be more than one cut at the September meeting, I think the data will be relatively supportive of rate cuts in the next six months, so there is little reason for markets to price in less in the near future.

The big risk is that J-Powell surprises the market with a hawkish stance at this week's Jackson Hole event, which could trigger a near-term reversal of the aggressive rate cuts that have been priced in. But overall, given the near-term inflation and employment outlook, monetary policy should support risk assets over the next few quarters. Importantly, easing monetary policy in a robust economy and with already loose financial conditions is, in my view, a recipe for a plunge in equity prices.

The economic outlook remains constructive, although not outstanding

Speaking of the growth picture, from an economic perspective, data has been significantly less supportive of the stock market in recent months. Although the majority of leading indicators have been relatively supportive of the economic cycle over the medium term and continue to do so (as we can see below), the market has aggressively priced this in during the first half of the year.

I recently wrote here at length about my forecast for the US and global business cycles. My overall forecast is that the US business cycle appears constructive, with the recent weakness in the hard data coming from the areas of greatest decline, namely income and employment.

Although some of the short-term economic indicators have weakened in the last quarter (such as the spread between new orders and inventories in the ISM index), leading to negative surprises in economic growth, most medium-term economic indicators remain constructive. This applies to the US at the top and the global business cycle at the bottom.

However, one key player in the global economy has been exceptionally weak recently: China. As we will see below, China's weak growth will hamper any upturn in the global business cycle in the near term.

Positioning, liquidity and financial conditions should continue to support equities

This aggressive pricing of the equity markets on the positive growth outlook left them vulnerable to short-term disappointments in economic growth, and that is exactly what we have seen in recent months. As we can see below, this is still essentially true today.

The market remains overbought relative to economic fundamentals. However, with the economic outlook looking far from pessimistic, we may need to see equity prices trade sideways for a little longer until some of the data and short-term leading indicators improve. If that happens, along with rate cuts and an easing of rate hikes by the Fed, the uptrend in equity prices should reignite.

But for now, my stock market growth quadrant remains in the bearish zone.

The same can be said about my growth vs. inflation quadrant.

But we must remember that economic fundamentals are not the only driver for equities. Liquidity and financial conditions are also important considerations and as we can see below, they are currently supporting the market. Importantly, two important factors, namely global liquidity, have risen and the dollar has fallen in recent weeks. Inflationary pressures and oil prices also remain at comfortable levels for equities.

Meanwhile, August also saw a very constructive washout of overexaggerated sentiment and positioning as part of the sell-off. Although asset managers remain massively overweight in equities, hedge funds and systematic/trend-following positioning have moved to much more favorable levels. We have also observed that investor surveys have returned to much more neutral levels.

Currently, sentiment and positioning are no longer as big a headwind for the market as they were a month ago.

We have also seen a significant improvement in stock market data over the past few weeks. While my pro-cyclical index is trending lower as cyclical and economically sensitive stocks continue to underperform the market, my overall stock market data index has soared. The high beta/low beta ratio, credit spreads and the dollar are the most supportive factors at the moment.

All in all, this means that my dashboard with stock market indicators shows predominantly neutral to optimistic values.

Also worth mentioning is the Zweig Breadth Thrust buy signal, which triggered the recent rally after the August sell-off and is generally one of the most reliable buy signals for stocks in the medium term.

One final point I'd like to mention, however, is seasonality, another factor that could put pressure on stock prices in the short term. Not only are stock prices generally sideways or declining during the September to early October period, but we're also currently in one of the longest monthly option expiration periods this year. This makes the market particularly vulnerable to negative currents in the weeks leading up to mid-September.

Therefore, volatility is generally much higher at this time of year.

This dynamic by no means justifies a sell-off, but is a point worth highlighting in the context of the market remaining heavily overbought relative to underlying economic fundamentals. As such, I remain cautious on equities in the short term, but relatively constructive on risk assets in the medium term.