Stocks may have put the debt ceiling behind them, but here are more risks to the 2023 market rally

By Joseph Adinolfi

Fraught negotiations in Washington have yielded a deal on raising the U.S.'s borrowing capacity without sending the stock market into a tailspin, as some on Wall Street had feared they might. But more risks may lie ahead.

Investors who spent the better part of the past month fixated on the welter of debt-ceiling related headlines may have missed a major shift in expectations for Federal Reserve monetary policy. Instead of expecting the Federal Reserve to refrain from raising interest rates again in June and deliver multiple interest-rate cuts later this year, traders are currently forecasting at least one more rate hike when the Fed meets next month.

See: Debt-ceiling deal: Here's what's next as it passes key hurdle in Congress

Recently, Dallas Fed President Lorie Logan and other senior officials have expressed concerns that inflation isn't slowing quickly enough, which they say warrants more interest-rate hikes.

Higher interest rates are typically anathema to stocks since they threaten lofty valuations by boosting the returns that investors can reap with far less risk by parking their money in Treasury bonds, money-market funds, or a savings account.

So far, this shift hasn't had much of an impact on the highflying technology stocks that have driven much of this year's gains in U.S. stock indexes. Some on Wall Street think this could change as the Fed appears set to keep interest rates elevated until the recession that markets have been expecting has actually arrived.

What other risks lie ahead for markets? Here are a few more that should be on investors' radar.

A stronger dollar could create problems for stocks

The Fed's rapid interest-rate hikes in 2022 helped push one closely watched gauge of the U.S. dollar's value to its highest level in more than two decades back in September.

But as U.S. stocks have risen from last October's lows, the dollar has retreated, with the ICE U.S. Dollar Index falling more than 10% between its late-September peak and its 2023 low reached in early February.

Defying worries about the U.S. debt-ceiling and talk of de-dollarization, the currency has started to claw its way back up. On Wednesday, the ICE U.S. Dollar Index , a gauge of the greenback's strength against major currenciess, climbed to 104.63, its highest level since March 16, according to FactSet data.

Tom Essaye, founder of Sevens Report Research and a former trader at Merrill Lynch, warned clients that a resurgent dollar could threaten to derail the stock market's year-to-date gains. Surging megacap technology stocks, which have driven the bulk of the market's gains, are particularly vulnerable, he added.

"[D]ollar strength typically has negative implications for multiple asset classes including the stock prices of companies that have a lot of exposure to international revenue sources and commodities," Essaye said.

"And if the dollar continues higher as we currently expect that it will, those various dollar-sensitive asset classes will begin to feel the pressure of the rising greenback."

Stubborn inflation remains a problem

When the Fed delivered its 10th consecutive interest-rate hike in May, raising its policy rate by 25 basis points, Chairman Jerome Powell suggested that it might be the last one of the cycle.

More recently, a group of senior Fed officials have pushed back, arguing that sticky service sector inflation must be dealt with before the Fed can declare victory.

On Tuesday, Thomas Barkin, president of the Richmond Fed, said inflation wouldn't dissipate as quickly as consumers had probably hoped.

See:Fed's Barkin says inflation will be 'more stubborn than many people would hope'

Last Friday the PCE index, the Fed's preferred inflation gauge, showed prices for goods and services rose 0.4% in April while on a year-over-year basis, the pace of price rises has gotten stuck in the 4% to 5% range.

Market-based gauges of what's coming down the pike have also been on the rise: the five-year/five-year forward inflation expectation rate recently touched its highest level since November, according to data from the St. Louis Fed.

Stubborn inflation has been cited by many analysts on Wall Street as a potentially intractable problem for markets.

"While the prospect of a debt-ceiling compromise this week is positive for risk sentiment and may support stocks in the near term, we still think the risk-reward balance for broad U.S. equities remains unfavorable amid other macro challenges," said Mark Haefele, chief investment officer at UBS Global Wealth Management, in a note emailed to clients and shared with MarketWatch.

A robust U.S. labor market is frequently cited as one of the biggest impediments to crushing inflation. Job growth has continued despite the Fed raising interest rates by roughly 5 percentage points in a year.

The market will receive another update on the state of the U.S. labor market on Friday, when monthly jobs numbers are released by the Labor Department.

Market leaders could throw in the towel

From Silicon Valley to Wall Street, economists, venture capitalists and old-fashioned stock pickers have been buzzing about the artificial intelligence revolution, and its potential for boosting productivity and, by extension, corporate profits and economic growth.

The AI craze has helped push the Nasdaq Composite, a market-cap weighted gauge that incorporates all stocks traded on the Nasdaq exchange, and the Nasdaq-100 , which features just the top 100 Nasdaq stocks, to reverse some of the losses from last year.

Some of last year's most hard-hit megacap stocks have logged staggering gains. Chip maker Nvidia Corp. (NVDA) has risen nearly 170% since Jan. 1, joining a small club of U.S.-traded stocks with valuations north of $1 trillion.

Its latest gains followed a blockbuster sales outlook as the company said it expects to sell $11 billion in merchandise during the quarter ending in June. That would be roughly 33% higher than the company's previous quarterly sales record.

Meanwhile, both Apple Inc. (AAPL) and Microsoft Corp. (MSFT) are within a few percentage points of their record closing highs.

The market has relied heavily on megacap stocks to drive the rally in the S&P 500 index. A quick glimpse at the Dow Jones Industrial Average, which is down more than 1% for the year, can quickly illustrate the consequences for markets if companies like Google parent Alphabet Inc. (GOOGL) or Facebook parent Meta Platforms Inc. (META) should fall back under the weight of their lofty valuations.

Skeptics like to point out that Nvidia Corp. is currently valued at roughly 50 times its expected earnings over the next 12 months, according to FactSet data. That is below the five-year high of 70.6 from 2021, but still extremely frothy compared with the S&P 500's forward EPS of 18.3.

Some longtime market watchers are warning that the AI craze is beginning to remind them of the dot-com days of 2000. Others noted that megacap growth tech stocks are particularly sensitive to interest-rate expectations, which could create issues if inflation doesn't swiftly subside.

"The tech sector has that turn-of-the-century smell to it. Then it was 'anything'.com and stocks rose. Every company was an internet company. AI could be similar as investors fall over themselves to snap up companies selling for egregious valuations," said Paul Nolte, of Murphy and Sylvest Wealth Management, in emailed commentary.

U.S. stocks were headed lower on Wednesday, with the S&P 500 down 0.8% at 4,171, while the Nasdaq Composite was off by 0.7% at 12,932. The Dow Jones Industrial Average was off by 0.9% at 32,753.

-Joseph Adinolfi

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06-03-23 0919ET

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