Wall Street’s rise could be a false dawn

While there were some fears that the Fed would add another 75 basis point hike next month, investors are now expecting a 50 basis point hike.

Essentially, markets are pricing in more rate hikes this year, but in smaller increments as the Fed gains confidence that inflation, while still high, is declining. While there are analysts who believe the Fed will hike rates again next year and that the federal funds rate will peak at a 4 percent ahead of time, markets are priced a little closer to 3.5 percent.

There were fears that Jerome Powell's Federal Reserve would add another 75 basis point hike next month, but investors now expect a 50 basis point hike.

There were fears that Jerome Powell’s Federal Reserve would add another 75 basis point hike next month, but investors now expect a 50 basis point hike.Recognition:AP

Equity markets are very interest rate sensitive because interest bearing securities are an alternative to equities, but also because long bond interest rates are used to calculate the net present value of future cash flows as a core approach to valuing companies. The lower the yield on the benchmark 10-year Treasuries used to discount these cash flows, the more they’re worth.

Stepping back from the shift in markets since mid-June, it appears they are signaling that the Fed can bring inflation under control without tightening monetary policy enough to plunge the US economy into a deep and prolonged recession falls. That doesn’t rule out something flat and short, but it’s certainly a more optimistic view than the worst fears earlier this year.

This optimism was bolstered by the first real signs that the dysfunctions in global supply chains, which have been a major factor behind soaring inflation rates around the world, are easing, with the cost of shipping containers across the Pacific, for example, falling to around $1,000 a Third of what it cost a year ago.

It was also compounded by the drop in oil prices from more than $123 a barrel to around $97 a barrel and a consequent drop in US gasoline prices from more than $5 a gallon to less than $4 supported per gallon. The rise in oil prices after the Russian invasion of Ukraine contributed to the increase in inflation.

Of course, for the stock market rally to continue, the “hard” (if not premature) approach of the world’s major central banks, including the Reserve Bank, must succeed in bringing inflation rates down significantly and ensuring that they remain on a clear trend to the targeted level of around two percent within the first half of next year.

This will result in a significant slowdown in economic activity and a rise in unemployment rates from near record lows.

While investors and markets are forward-looking – pricing in what they expect six to 12 months to be, rather than current conditions and conditions – they may be underestimating what it will take to meet central bankers’ goals.

It’s entirely conceivable that last month’s uptrend could be one of those bear market rallies – “dead cat bounces” – that fool risk-takers into believing the worst is over. The rate hikes have not yet had a significant impact on economic activity and have yet to be reflected in corporate earnings. Monetary policy takes time to bite.

Despite the apparent conviction of equity investors, these times remain highly uncertain.

It’s also quite uncomfortable to see volatility (as measured by the VIX or “fear” index) falling back to below 20 levels from the mid-30s in mid-June, even as the war in Ukraine continues and Taiwan acts as one new focus, tensions between China and the US are rising.

China’s flagging economy and Europe’s energy crisis will also weigh on global growth, even as US and other Western economies continue to slow.

A buoyant stock market is inconsistent with a global recession, and easing in global market interest rates, despite central bank efforts, may be a better indicator of impending deterioration in economic conditions.

It’s worth noting that retail investors have returned to the market — “meme” stocks like Bed Bath and Beyond and AMC Entertainment have soared during the current rally — which is something of a reverse signal that the market is still is vulnerable.

It is premature to claim the battle against the biggest burst of inflation since the 1970s has been won, or to factor in rate cuts in the second half of next year and to believe that the fundamentals are in place for a new cycle of rising stock prices.

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US inflation may have peaked and others may be on the horizon, but much of the world inflation remains at historically high levels, current economic data is mixed and confusing, the real consequences of efforts to control it remain to be and there is a disconnect between what the Fed has done and said and the interpretations of its actions and statements that stock investors are pricing in.

Despite the apparent conviction of equity investors, these times remain highly uncertain.

The Market Recap Newsletter is a summary of the trading day. Get it every useday afternoon.

https://www.smh.com.au/business/markets/sharemarkets-are-surging-but-it-could-be-a-false-dawn-20220815-p5b9ub.html?ref=rss&utm_medium=rss&utm_source=rss_business Wall Street’s rise could be a false dawn

Brian Lowry

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