What makes the rally unique, but also dangerous

There is currently a unique rally underway on the US stock markets, the likes of which have never been seen before. Wall Street is not only raising the stakes, but is going “all in” on a dreamed-of Goldilocks scenario, although the warning signs are already obvious. Nevertheless, market participants are simultaneously betting on a decline in inflation, aggressive interest rate cuts by the Fed and a continued robust economy – in other words, the best of all stock market worlds. A risky bet.

It started badly. But four weeks after the worst turmoil and strongest outbreaks of volatility since the pandemic, August will go down in stock market history as another great gesture of Wall Street's confidence in its ability to fathom the future.

Stock markets: Best of all stock market worlds

According to a Bloomberg report, conviction levels are rising sharply across all asset classes in the markets. For example, exchange-traded funds that track government bonds, corporate credit and equities have now risen in lockstep for four consecutive months, the longest period of correlated gains since at least 2007. With a gain of 25% over the past 12 months, the S&P 500 has never risen as much ahead of the first rate cut of an easing cycle, according to seven decades of data compiled by Ned Davis Research and Bloomberg.

Traders are jumping into the bets with zeal, even as serious questions linger about the economy and inflation – and how central bankers will respond. Even before the Federal Reserve began to act, bond markets have priced in a host of rate cuts, while default risk metrics are falling and rising stock markets are betting heavily on an economic boom.

Everything has to run perfectly

Gains of 2.3% for the S&P 500 in August, 1.8% for an ETF that tracks long-dated Treasuries, and 1.5% for investment-grade bonds are all a major show of force from cross-asset bulls who are convinced that Fed Chair Jerome Powell will cut rates in a healthy economy. All in all, the bets depend on how economic data — which has been very fickle lately, to say the least — plays out between now and the Fed's Sept. 18 meeting.

“Everything has to be perfect,” said Lindsay Rosner, head of cross-sector investing at Goldman Sachs Asset Management. “We have to continue to have economic growth that is at or above trend.” We have to have a labor market that is not too hot and not too cold. And inflation that continues to cool. Because that would allow consumers to continue to consume. “All of these things have to be in perfect balance,” she says.

Fragile stock markets

The stock markets have recovered, but the turbulence at the beginning of August shows how fragile the existing consensus is: the rally is on thin ice. A single government report – the US labor market data for July – triggered shocks that caused Wall Street's fear barometer, the VIX, to briefly rise above 65, the highest level since the Corona crash. The labor market report for August is due next Friday. The economists' forecasts compiled by Bloomberg assume a job increase of between 100,000 and 208,000.

Also due next week are data on U.S. manufacturing, durable goods orders and initial jobless claims, all of which have the potential to influence sentiment at a time when growth has become a stock market obsession. Speaking in Jackson Hole, Wyoming, Powell said last week that the direction of future monetary policy was clear but that “the timing and pace of rate cuts will depend on the legacy data, the evolving outlook and the balance of risks.”

A dovish Fed played a key role in Wall Street coming out of its silly season unscathed and quickly putting the stock market flash crash of early August behind it. All four major asset exchange-traded funds (tickers: SPY, TLT, LQD, HYG) rose at least 1% this month, while more than $1 trillion was invested in American stocks alone.

Upcoming interest rate turnaround fuels rally

Traders piled into everything from small-cap stocks to speculative bonds, confident the world's largest economy will avoid a consumption-led downturn despite a weakening labor market. Funds focused on U.S. stocks saw inflows of $5.8 billion for the ninth straight week, and those specializing in high-yield bonds attracted $1.7 billion, EPFR Global data compiled by Bank of America showed.

For now, at least, neither economic data nor corporate earnings scream danger. But if there is one lesson to be learned from the August turmoil, it is that the usual bets – long on artificial intelligence and the yen carry trade strategy – can suddenly backfire.

To get a sense of the uncertainty, consider the path of rate cuts priced into Fed funds futures. In January, as inflation fears were easing, bond traders were betting on about six rate cuts in all of 2024, with the first coming as early as March. When inflation proved more stubborn than forecast, those bets were scaled back, and by April only one rate cut was expected.

The consensus now is that the Fed will begin its easing cycle next month, cutting interest rates four times by a quarter point each through December.

Fed and markets are always wrong

“The reality is that both the Fed's dotplot estimates and the market's expectations are always wrong,” said James St. Aubin, CIO at Ocean Park Asset Management. “I could easily see three rate cuts this year. Four may ring pretty extreme. That would probably only happen if the state of the economy continues to deteriorate.

At the same time, caution has proven to be a costly investment philosophy this year. In the credit market, the dreaded maturity wall – the threat of painful refinancings by corporate borrowers at higher interest rates – is collapsing as the level of looming debt repayments in the junk bond market is heading toward its largest in at least a decade. Credit default swaps, also instruments used to hedge credit risk, have declined, while the Markit CDX North American High Yield Index has remained near its cheapest level since early 2022.

Is Big Tech a threat to the stock markets?

Rather than taking a hit from higher borrowing costs as many feared, corporate profits may actually benefit from the jump in benchmark interest rates from 0% to over 5%. This allowed cash-rich companies, especially the big technology companies, to enjoy a steady stream of income from their bond investments.

According to Kaixian Tan, an analyst at Gavekal Research, the entire rise in non-financial corporate earnings since 2022 has been driven by a decline in interest payments on a net basis – a counterintuitive situation where booming interest income largely offset rising debt service costs as interest rates rose. But now that interest rates are falling, that tailwind is in danger.

“Interest rate cuts will reduce companies' interest income and thus their profits,” Tan wrote in a note this week. “This will disproportionately affect large tech companies, which are sitting on large piles of cash, and could lead to their relative underperformance.”

For Jack McIntyre, global bond portfolio manager at Brandywine Global Investment Management, predictions in the post-pandemic world are almost hopeless. If he had to make a guess, it would be that economic resilience will weaken next year and that bonds will outperform stocks in that environment.

“For me, a soft landing is just a hard landing postponed,” he said.

The next 12 months can only be good for the stock markets if the Fed continues to lower interest rates and there is no recession.

FMW/Bloomberg

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