After a shaky start, Wall Street staged a strong rally last week, ahead of a critical inflation number scheduled for next week. The gains were broad, led by the tech-heavy Nasdaq, which had suffered the most significant losses since the Fed’s hawkish statement in the Jackson Hole bankers’ economic symposium at the end of August.
One of the catalysts behind the turnaround in U.S. equities was a larger-than-expected hike of Eurozone rates by the ECB on Thursday. The move reassured traders and investors that the Eurozone’s central bank is serious about fighting inflation. In addition, higher eurozone rates helped halt the dollar’s advance against the euro, a favorable development for U.S. multinationals with extensive exposure to the Eurozone market.
Another catalyst was the weaker inflation numbers out from China, still mired in lockdowns that have been taking their toll on the domestic economy. Consumer prices in the world’s second-largest economy rose at a lower-than-expected rate in August, while producer inflation reached an 18-month low.
China is the world’s largest commodity consumer and, therefore, the pace-setter for commodity prices worldwide. Thus, lower producer prices in China will eventually mean lower commodity prices in the U.S., including oil and gas prices, which have been falling in recent weeks.
These catalysts created a new narrative on Wall Street that inflation has peaked, and things will look better next week when the U.S. government reports August inflation numbers. And that could help the Fed engineer a soft landing, an ideal scenario for equities.
“Markets are attempting to digest and appropriately factor risk into asset prices,” Adam Coons, a portfolio manager at Winthrop Capital Management, in an email to International Business Times.
Coons thinks that investors are convinced that the Fed will manage to bring inflation under control without pushing the world economy into recession.
Thomas Samuelson, the chief investment officer at Vineyard Global Advisors, had a similar explanation for investor behavior.
“The bounce in the stock market over the last three days is due to the enthusiasm that inflation may be peaking and the Fed may be able to wind down its rate hikes and tightening cycle soon,” he told IBT in an email.
Coons and Samuelson both think that markets may have run ahead of themselves and that last week’s rally may not be sustainable.
Coons is concerned about economic fundamentals. Like a slow-down in China’s exports, which points to a slowing in global demand.
He’s also worried about a couple of more things. First is the decline in consumer purchasing power due to lower real wages. Second is the Fed’s removal of liquidity from credit markets, and the inverted yield curve, which undermine lending.
“These factors point to an economic hard landing,” Coons said. “While this does not mean that stocks necessarily decline, it does increase the probability of a reversal of this week’s stock market rally.”
Samuelson is concerned about weak technicals, like a “very mediocre” market bounce. It suggests that U.S. equities may be in for another bear market rally, doomed to fade away, as was the case with the June-August rally.
In addition, he’s concerned with seasonality.
“Stock market seasonality is also unfavorable through mid-to-late October,” Samuelson said. “Should we see a retest or overshoot of the June lows, it would provide a more attractive risk-reward entry point for investors.”
John Zolidis, president of Quo Vadis Capital, raised another potential headwind for the recent market rally — the revival of “policy error” talk.
“A ‘policy error’ is a cute way to allude to a terrible recession provoked by overly aggressive interest rate hikes,” he said. “And that shouldn’t be positive for stock prices.”