Why the US equity market may be getting ahead of itself

Fed is still likely to raise rates into 2023, as it seeks a sustained decline in price pressures before considering a change in policy

The Nasdaq composite index is up by more than 20 per cent since mid-June. Bloomberg

US equity markets have rallied over the past month and a half, with the S&P 500 index up about 16 per cent since its mid-June low, and the tech-heavy Nasdaq composite index up by more than 20 per cent over the same period — the technical definition of a bull market.

The rally has confounded many analysts, coming as it has against a backdrop of slowing growth and high inflation.

Recession fears have increased in recent weeks, with economic data showing a slowdown in manufacturing activity, rising jobless claims and a second quarter of declining gross domestic product in the US.

This is reflected in the most inverted yield curve since 2000. In the US, an inverted yield curve where 10-year treasuries yield less than two-year ones, has historically predicted an economic recession with a high degree of accuracy.

The rally in equities even as macroeconomic conditions are seemingly worsening reflects the market’s belief that the US Federal Reserve will have to cut rates in 2023, as inflation slows and unemployment rises.

July’s inflation data, which came in better than expected last week, provided further support for this view. The headline Consumer Price Index fell to 8.5 per cent in July, down from a multi-decade high of 9.1 per cent in June, although this was largely owing to lower energy prices.

Core inflation, which excludes volatile food and energy prices, was unchanged at 5.9 per cent year on year last month, reflecting sustained inflation in housing, health care and other services.

Fed officials quickly pushed back against the market’s rosy interpretation that the central bank will not have to raise rates as much as previously thought, now that consumer inflation has seemingly peaked.

Several Fed presidents noted that they still expect rates to rise into 2023, and that although the July inflation print was a good one, they will need more evidence of a sustained decline in price pressures before they consider a change in policy.

The argument that inflation has peaked also assumes no further supply shocks with respect to energy and food. While global oil and food commodity prices have eased in recent weeks, and there are indications that food exports from Ukraine are resuming, any further disruptions to supply or a recovery in demand could again put upward pressure on these key commodities.

Opec+ has limited capacity to increase production, and the war in Ukraine means that energy supplies from Russia to the EU remain constrained and could be disrupted further, potentially causing shortages this winter.

China’s demand for oil is also expected to rebound as Covid-19-related restrictions on activity are eased, and the International Energy Agency recently increased its forecast for oil demand growth this year, saying that high natural gas prices are encouraging companies and power generators to switch from gas to oil, particularly in Europe and the Middle East.

While Emirates NBD is optimistic that inflation will continue to ease in the coming months, the pace of decline is likely to be slow. Indeed, headline and core CPI will remain well above the Fed’s 2 per cent goal by year-end.

Meanwhile, the US labour market still looks exceptionally strong, with another 528,000 jobs added in July and a further decline in the unemployment rate to 3.5 per cent.

Consequently, we expect the Fed will continue tightening monetary policy in order to cool demand and forecast another 150 basis points in rate hikes over the rest of this year.

Khatija Haque is chief economist and head of research at Emirates NBD.