Signs of strength in the U.S. economy have lifted stocks in the face of surging Treasury yields and hawkish Federal Reserve expectations, though some investors feel the rally may be on borrowed time.
Stronger-than-anticipated reports on inflation, employment, and retail sales have amplified expectations for how much higher the Federal Reserve will need to hike rates and triggered a surge in Treasury yields – naturally a negative development for stocks.
Yet the strong data has also eased fears of a looming recession that plagued Wall Street at the end of last year, giving investors a reason to hang on to equities, at least for now. The S&P 500 has gained 6.6% for the year-to-date, even as benchmark 10-year Treasury yields have increased almost 50 basis points from their lows of the year.
Only 24% of global fund managers now predict a recession, a drop from 77% in November, according to a recent survey by BofA Global Research.
“Everyone came into the year thinking that there’s an imminent recession in the first half of 2023,” said Charlie McElligott, managing director, cross-asset strategy at Nomura Securities. “They got caught off guard because there’s much more resilient domestic and global growth.”
Investors’ boldness can be seen in the resilience of the Nasdaq Composite Index, home to most of the tech and growth stocks that were especially sensitive to higher yields in 2022, when it recorded a 33% loss.
Based on historical regression, the Nasdaq should have gone down between 5% and 10% based on the rise in two-year yields since the Fed meeting earlier in February, according to a report from analysts at JPMorgan, including chief global markets strategist Marko Kolanovic. Instead, the index gained 0.3% over that time and has surged 13.3% for the year to date.
Some investors say the market’s strength is unlikely to continue much longer, especially if yields keep increasing. Higher Treasury yields can hurt stocks as they give equities investment competition, increase companies borrowing costs, and weaken valuations.
Many also hold that a recession has been delayed but not dodged. A severe slowdown could await in the second half of 2023, especially if rebounding inflation compels the Fed to maintain rates at a higher level for longer to cool prices.
“The market in equities is just not appreciating that there will be more stepping on the brakes from the Fed and more earnings at risk of going lower,” said Torsten Slok, Chief Economist at Apollo Global Management.
“Everyone wants to buy the dip in the stock market but the risk is that with inflation at 6.4%, the Fed is just not done.”
There are already signs that investors may be growing worried over the economy’s strength. The S&P 500 fell 1.4% on Thursday, aided in part by a stronger-than-predicted U.S. producer price index reading.
Bearish investors also note other factors that tend to hurt stocks have emerged in recent weeks. Real yields – which measure the return on Treasury yields after inflation – have increased, bringing the yield of the U.S. 10-year Treasury Inflation-Protected Security close to its highest level since early last month. That can dull the attractiveness of stocks, which are seen as much riskier than U.S. government bonds.
Rising yields have also stopped a drop in the U.S. dollar, which fell from a two-decade high in the back half of last year but is now up almost 3% from its low of the year against a basket of currencies. A stronger dollar tends to weigh on the profits of U.S. multinationals and exporters.
In BoFA’s survey, 66% of fund managers said the move in stocks, which started in October and has seen the S&P 500 gain 14% from that month’s lows, was a bear market rally instead of a new bull market.
Still, some investors maintain risks are tilted in favor of stocks, with the majority of the Fed’s monetary policy tightening likely in the rear view mirror and valuations widely lower after 2022’s 19.4% selloff in the S&P 500.
Buy Crypto NowLara Reinhard, senior portfolio strategist at Janus Henderson Investors, is abstaining from technology and growth stocks but concentrating on shares of companies that dish out dividends as a hedge against inflation.
“We are starting at more normal valuations and in some cases cheaper valuations than in the last few years,” she said.
In the meantime, stocks are getting substantial support from retail investors, who put in a record net average of $1.51 billion per day into U.S. stocks over the last month, according to Vanda Securities.
“Retail investors have plenty of dry powder in the form of capital parked in money market funds that could be deployed in the equity space once confidence about future market returns increases more broadly,” the firm’s analysts wrote.