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Written by: Kevin McCreadie, CFA®, MBA | AGF
After an up and down start to the year, equity markets like the S&P 500 Index have traded in a much tighter range over the past couple of months. Why do investors seem so directionless?
Investors are playing the waiting game right now. In particular, they’re waiting for the U.S. economy to soften enough for the U.S. Federal Reserve to cut rates. Such an event — as the theory goes — would catalyze risk assets and lead to a much-desired breakout in stocks as lower rates spur demand and drive the economy (and profits) into a new expansionary cycle.
Yet that reality may not be close at hand. Yes, there are signs that economic growth is weakening, but the data is mixed at best. Take the U.S. labour market, for instance. Even though weekly jobless claims have ticked up over the past few months, the U.S. unemployment rate edged down in April and hit a 50-year low of 3.4%. Moreover, while the recent bank turmoil could result in tighter credit conditions going forward, the U.S. consumer remains remarkably resilient to date — at least based on April’s 0.8% increase in consumer spending.
That could change of course. In fact, we believe it’s very likely that the U.S. economy is headed for a recession due to the lag effects of raising rates so quickly. But the Fed probably needs more definitive evidence of a slowdown before indicating a readiness for an actual rate cut. Instead, it seems poised to raise rates one more time in June before taking a potential pause to assess the ongoing strength of the economy and decide either that more rate hikes are warranted to bring inflation back down to the central bank’s target of 2% or that looser monetary policy is finally necessary to help prevent a deep and protracted recession from occurring.
Why is a Fed “pause” not enough of a catalyst to move equity markets significantly higher from here?
It’s a step in the right direction, but how the market reacts will largely depend on how long the Fed remains on hold once it makes that decision. Remember, markets are currently pricing in two rate cuts by the end of the year so if there’s an extended pause, it’s unlikely that stocks would rally for long.
That doesn’t mean markets would necessarily fall from here if the Fed doesn’t start cutting rates by the end of the year. They could easily remain rangebound like they have over the past two months. Still, without another positive catalyst on the horizon, investors may be more susceptible to downside risks or “potholes” than would otherwise be the case.
For instance, the possibility of a U.S. debt default had the potential to severely disrupt markets (and still could if U.S. Congress is unable to reach a final agreement in the next few days), and so too does the Ukraine War — especially if Russia continues to lose battleground and ramps up its aggression in more sinister ways. And what happens if inflation proves stickier than expected? Does that mean the Fed ends up raising rates even more in the coming months?
At best, then, it seems like markets are set to tread water for a little while longer. In doing so, it’s also likely that investors continue crowding into a small number of “quality” technology stocks that are thought to provide greater downside protection in this type of environment. But that’s not necessarily a good thing. Healthy equity markets are generally those that offer broad-based opportunities, not narrow ones, and the market’s ongoing fixation with just a handful of stocks could lead to more volatility if a new and legitimate shock to the system materializes in the days ahead.
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