Investors have spent most of 2023 waiting for a sign that inflation was on the run and interest rates had peaked, at which point they would fire the starting gun on the next big stock market rally.
It was a simple, attractive, optimistic theory, but investing is never simple, and now the narrative is taking a different turn.
We finally see signs that inflation has been shot down and the US Federal Reserve can soon declare its work done, so what happens?
Investors lose their nerve and the US stock market dips on talk of stagflation, disinflation, recession and debt instead.
Instead of popping corks, investors are mired in gloom. Which seems odd given that they are close to getting exactly what they’ve been waiting for.
Some people are never happy. Or are there more worrying issues at play?
July’s US inflation figure wasn't brilliant, with prices rising for the first time in 13 months, from 3 per cent to 3.2 per cent. However, it wasn’t bad either, as markets had expected 3.3 per cent.
The result is “encouraging”, although returning inflation to the Fed’s 2 per cent target remains a challenge, says Ryan Brandham, head of global capital markets, North America, at Validus Risk Management.
“The Federal Open Market Committee will want to see yet more data before deciding if progress has been fast enough to warrant a pause in September.”
David Alexander Meier, economic researcher at Julius Baer, reckons investors will get that pause as the US labour market cools.
“We believe the Fed has completed its hiking cycle,” he says.
Yet, Richard Flax, chief investment officer at digital wealth manager Moneyfarm, says “the Fed remains wary of declaring victory too soon”.
That’s the first reason why the prospect of hitting peak interest rates is failing to fire up investors. They don’t believe it yet.
The second reason is that they have belatedly started worrying about US debt, following rating agency Fitch’s shock move to cut the country’s credit rating from AAA to AA+, citing serious fiscal challenges and “steady deterioration in standards of governance”.
Steen Jakobsen, chief investment officer at Saxo Bank, is also worried as the total clicks past $32.7 trillion and carries on rising at the rate of $5 billion a day.
Interest payments total $1 trillion a year, sucking money out of the economy, but no politician is willing to tackle the growing debt pile.
Mr Jakobsen reckons the US is now heading towards stagflation and a “rolling recession”, bringing the S&P 500’s strong 2023 run to an end.
By July 31, the index had soared 19.9 per cent to 4,588.96, reversing most of last year’s losses. It has since slipped while the Nasdaq has just posted its first two-week loss of the year, and there could be worse to come.
Mr Jakobsen sees the S&P 500 plunging as low as 4,045 and says this could persuade the Fed to slash interest rates – possibly even before the end of the year.
Falling earnings, slowing growth, and rising wage and energy costs are squeezing margins, while consumers have exhausted their savings, he says.
“The student loan forgiveness programme ends in October and 40 million Americans will start paying an average of $200 to $300 a month again. This is a huge loss of purchasing power at a time when the Fed’s 5.25 per cent interest rates are starting to impact the real economy,” Mr Jakobsen adds.
Russ Mould, investment director at AJ Bell, is also worried about debt.
“The Biden presidency’s policies mean US government spending is surging even as tax receipts weaken, a sign that the underlying economy is not quite as strong as equity markets like to think,” he says.
The US budget deficit for the fiscal year to September 2023 already exceeds that for all of 2022, with three months of data still to come.
“As Fitch’s downgrade makes clear, this is not sustainable,” Mr Mould says.
The third big worry centres on another economic superpower, China, with markets spooked by a bigger-than-expected 12.4 per cent drop in exports in July.
Traders were looking for an excuse to dump stocks and lock in recent profits and this was it, says Chris Beauchamp, chief market analyst at online trading platform IG.
“The odds of a sizeable correction are now much higher. A pullback is certainly overdue, and the recent outbreak of confidence about a soft landing also leaves markets vulnerable in the short term,” he adds.
chief investment officer, Saxo Bank
The International Energy Agency has warned of a tough 2024 as it downgrades growth forecasts for global oil demand citing “lacklustre economic conditions”, along with other factors such as the shift to electric vehicles.
Whispers of stagflation are making the rounds on Wall Street again as fresh headwinds become more apparent, says Vijay Valecha, chief investment officer at Century Financial.
“The banking crisis and US debt ceiling stand-off earlier in the year also rattled markets,” he says.
Consumers have borrowed heavily too, with credit card debt up 16 per cent to surpass $1 trillion for the first time ever, he says, with credit card delinquencies hitting hit an 11-year high.
Pressure could build as we still cannot rule out Fed interest rate hikes in both September and November, he adds.
As high interest rates squeeze profits, economic reality “is bound to catch up with inflated share prices soon”, Mr Valecha says.
“Investors should remain alert and keep an eye out for signs of market overextension or capitulation.”
The Fed faces a monumental balancing act as it tries to fight inflation without sinking the economy and there’s still a chance it could still be rewarded with a soft landing, says Victoria Scholar, head of investment at Interactive Investor.
“A number of Wall Street analysts have upgraded their US growth expectations, including Bank of America, which no longer anticipates a recession in 2024, while JP Morgan also expects the US to avoid a recession,” she says.
So far, the US stock market has been surprisingly resilient, given all the economic headwinds, Ms Scholar adds.
It may surprise again, but there is a growing sense that investors have jumped the gun as the war on inflation isn't over and even when it is, there are still $32.7 trillion reasons to worry about the global economy.
