Markets Brief: Rate Hikes May Be Over, But Is the Coast Clear for Stocks?

Anxious investors finally got some good news with October’s inflation data, cementing widespread agreement that the Federal Reserve has finally reached the end of its rate-hiking cycle. Stock and bond markets rallied, but strategists are warning that investors shouldn’t celebrate too soon.

Economic data is moving in the right direction and the labor market remains strong, but risks remain. Month-over-month numbers can be volatile and inflation is still high in the services sector. Not to mention how bond traders may be overzealous about the prospect of rate cuts next year.

“Don’t bring the party hats out of the boxes yet,” says John Stoltzfus, chief investment strategist at Oppenheimer Asset Management.

Stocks Climb As Inflation Cools

Consumer Price Index data released Tuesday showed that the inflation rate dropped to 3.2% on an annual basis in October. The Morningstar US Market Index climbed 2.2% on the day, and as of Friday afternoon was up 3.9% for the week. Even areas of the market that have sat out previous rallies this year saw gains; the Morningstar US Small Cap Index jumped 4.7% on Tuesday.

On Wednesday, markets climbed even higher after more inflation data continued to point to an economic slowdown, as producer prices and retail sales both fell.

The jubilant market reflected optimism from investors that the Fed could finally stop raising rates since inflation appears to be under control. Some analysts who had been calling for an additional rate hike changed their tunes. “Today’s benign CPI report led us to change our Fed call,” Bank of America analysts said Tuesday. “We now think the hiking cycle is over.”

Gene Goldman, chief investment officer at Cetera Investment Management, points out that a reduction in interest rates could expand market breadth—the number of stocks within an index that participate in a rally or pullback. This year, analysts have repeatedly sounded warnings that just a handful of mega-cap technology stocks (which are often better equipped to handle rising rates) have been driving the entire market’s performance. “We expect the market to widen a bit,” Goldman says, which opens more opportunities for investors.

Strong economic data and more clarity around the path of interest rates is also contributing to optimism around earnings, Goldman adds. The fact that producer prices are falling faster than consumer prices—a good sign for corporate bottom lines—doesn’t hurt either. “The earnings recession is over,” he says.

Bond Traders Price In Rate Cuts for May

Meanwhile, traders in the bond market are now even more confident that the Fed will begin cutting rates next year. As of Friday, bond futures were pricing in a nearly 50% chance the Fed will cut rates at its May 2024 meeting. In all, traders expect about 1 percent point of rate cuts by the end of 2024, which would bring rates down from the current range of 5.25%-5.50% to 4.25%-4.50%.

Those predictions can change rapidly, however, and investors should take them with a grain of salt.

“Markets will move to price things in, but they don’t always get it perfectly right,” says Josh Jamner, an investment strategy analyst at ClearBridge Investments. The bond market’s implication that the Fed will cut rates consistently over the next year is “debatable,” he adds. “Nobody has a crystal ball. Nobody knows how the data is going to unfold. There could well be another patch of unfavorable data that comes out and causes the market to reprice.”

Jamner expects the Fed will wait longer than it typically does to cut rates, given lingering uncertainty and the risk of a second wave of inflation.

Risks Remain

Fed chair Jerome Powell recently acknowledged that risk himself. “We know that ongoing progress toward our 2% goal is not assured,” he said, alluding to “headfakes” in monthly inflation data that pointed towards progress when the larger trend didn’t match it. Powell has repeatedly assured market watchers that the central bank will not hesitate to raise rates again if necessary.

That means investors won’t be leaving their Fed-watching days behind any time soon (or probably ever). They’ll want to see “more progress” toward the Fed’s 2% inflation goal, according to Stoltzfus. There’s no guarantee that will happen immediately, given the volatility of month-over-month inflation data. Cetera’s Goldman points out that another hawkish voice, Loretta Mester of the Cleveland Fed, will be joining the central bank’s voting committee at the beginning of 2024.

A persistently strong labor market could also delay rate cuts.

“There are not many signs that it is truly weakening,” says Jamner. “It’s going to be a little bit of time until we get more clarity,” he says, given the lingering disruptions from the auto workers strike. Goldman adds that a strong labor market is also contributing to persistently high inflation in the services sector.

Uncertain, Volatile Markets Create Opportunity

Despite those risks, investors shouldn’t hold their breath waiting for a neat and tidy end to the inflation saga.

“There’s never an all-clear signal sounded over the market,” says Stoltzfus, who is bullish overall on the market despite his warning against premature celebrations. He explains that pockets of volatility create some of the “greatest opportunities” for investors. It’s a great time to look for stocks with solid fundamentals that get caught up in selloffs.

Jamner says that overall, positive movement on inflation is positive for risk assets like stocks, even if there’s uncertainty around the Fed’s exact path. In fact, that uncertainty is what creates the potential for successful bets on the market. He explains: “As an investor, [it] creates an opportunity around [the question of] ‘Do you have a differentiated view?’”

Goldman, who is also bullish on equities, is looking ahead to a dramatic uptick in volatility. “There’s going to be a lot of turbulence,” he says, which comes with its own advantages for long-term investors.

For the Trading Week Ended Nov. 17

• The Morningstar US Market Index rose 2.5%.
• The best-performing sectors were real estate, up 4.5%, and basic materials, up 4%.
• The worst-performing sector was consumer defensives, up 0.7%.
• Yields on 10-year U.S. Treasury notes fell to 4.44% from 4.61%.
• West Texas Intermediate crude prices fell 1.7% to $75.89 per barrel.
• Of the 849 U.S.-listed companies covered by Morningstar, 754, or 89%, were up, and 95, or 11%, were down.

What Stocks Are Up?

Gap GPS, Macy’s M, and Sunrun RUN.

What Stocks Are Down?

First Republic Bank FRCB, Cisco Systems CSCO, and Walmart WMT.