The stock market appears to be increasingly pricing in the possibility a historic rate hiking cycle from the Federal Reserve doesn’t end in a recession.
Take Tuesday’s market action for instance. Inflation data showed pricing pressure cooling quicker than expected. Yields tied to the 10-year Treasury (^TNX) saw their biggest daily drop since March, as investors increasingly bet the Fed is done hiking rates. The S&P 500 (^GSPC) and Nasdaq Composite (^IXIC) had their best days since April. And the small cap Russell 2000 (^RUT), which has lagged all year long, added 5% for its best day in a year.
For months, the team at Goldman Sachs has held a stance that the economy could skirt a recession, and David Kostin, the bank’s chief US equity strategist, thinks the recent moves in the market are a sign that investors are starting to price in that call themselves as the “economic surprises” like Tuesday’s CPI report continue.
“Many portfolio managers do not share [the view the economy keeps growing] in terms of their concerns and their risks,” Kostin said during a media roundtable on Thursday. “So to the extent that there’s information that really supports that view, our view, then the equity market does respond pretty sharply.”
What Kostin referred to as “economic surprises” have abounded recently. The most recent retail sales report showed consumer spending sliding, but “not falling off a cliff.” October jobs data revealed cooling wages, considered key to not having inflation reaccelerate, while jobs growth began to moderate.
This has led markets to position for a scenario commonly referred to as a “soft landing,” where inflation retreats to the central bank’s 2% target without the labor market tanking and unemployment running rampant as the economy tips into recession.
Soft landing bulls have had their hopes dashed before. On Feb. 1, Fed Chair Jerome Powell described the possibility of what he’s since called the Fed’s “primary objective.”
“I continue to think that there’s a path to getting inflation back down to 2% without a really significant economic decline or a significant increase in unemployment,” Powell said at the time.
But then a blowout jobs report released two days later surprised the market, and investors grew worried about the labor market growing at too fast a clip for inflation to keep falling. The soft landing hopes, at least for the moment, had soured.
“We’ve had much of the elements that are required for a soft landing in the most recent data,” EY chief economist Gregory Daco told Yahoo Finance in an interview on Thursday. “But people tend to be — and this is in part due to the Fed’s narrative — but people tend to be overly focused on any one month’s report.”
To be sure, a soft landing might be closer this time than when the market positioned itself for a rosy outlook back in February. There’s been nearly a year’s worth of data since then, and a growing consensus that inflation is cooling, the jobs market is no longer running unsustainably hot, and the Fed is done hiking interest rates.
The question remains if those trends can continue. Goldman Sachs chief economist Jan Hatzius says they will, noting that the path of disinflation is set to continue and that consumer spending should hold up despite excess savings getting depleted.
“We basically don’t expect the last mile of disinflation to be particularly hard,” Hatzius said. “And so that’s one reason why the title of our outlook report this year is ‘The Hard Part Is Over,’ because we think the hard part of disinflation without recession really has been what we’ve seen over the last year or year and a half … We think we’re very well advanced.”
But there’s still an argument that financial conditions could tighten significantly, as the Fed’s “higher for longer” interest rate campaign is expected to slow business activity. And the key will be what that means for the labor market, according to Daco.
If businesses are bringing in less money because their costs to borrow money are higher, they might cut head count. If one company cuts head count, then often another in the same industry might consider it, too, as the start of a recession can become a “vicious cycle,” Daco said.
And if layoffs come, unemployment rises. If fewer people have jobs, then there are fewer people to spend money and perhaps one of the “most anticipated” recessions ever finally comes.
“I don’t think we should be celebrating accomplishing that soft landing until we actually see inflation back close to that 2% target, and the economy is still moving forward,” Daco said. “That’s really the open question for 2024.”
As long as that debate remains open, it will be a key question for investors in 2024, too.
Josh Schafer is a reporter for Yahoo Finance.
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