【MACRO Insight】The dual challenges of the strong rebound of the US stock market and inflation risks

In the past month, analysts who closely follow U.S. stocks at investment banks such as BMO Capital Markets, Goldman Sachs and UBS have raised their year-end expectations for the S&P 500, expecting the index to continue its 22% gain in 2024. The S&P 500 has not had such a large year-to-date gain since 1997. These trends reflect that the economy and corporate profits have shown amazing resilience this year, and investors continue to pile into technology stocks that are expected to benefit from breakthroughs in artificial intelligence, so the gains have exceeded expectations.

The sharp rise in stock prices is causing Wall Street forecasters to scramble to raise their outlooks for the final stretch through 2024 — a so-called “strategist short squeeze,” similar to the rapid rise in stock prices that forces traders to cover bearish positions. It's reminiscent of last year, when they were caught off guard by a 24% surge in the S&P 500. With the S&P 500 above 5,800, UBS's Jonathan Golub and Patrick Palfrey on Tuesday raised their year-end forecasts for the index for the latest time. They raised their forecast to 5,850 from 5,600, while also raising their 2025 forecast to 6,400 from 6,000.

“Uncertainty about fiscal and monetary policy, as well as potential election outcomes, makes returns in 2025 far from certain,” Golub wrote Tuesday. But that doesn't stop him from betting on continued strength in stocks, noting that market risks are skewed to the upside with slowing inflation, Federal Reserve rate cuts, improving low-end consumer and business activity, and broad-based profit growth.

The confidence that the stock market can overcome looming uncertainty comes from experience. Many strategists have underestimated the gains of the U.S. stock market time and again. In January, the average forecast for the end of the year for the S&P 500 was 4,867, about 17% below the level where the index traded on Tuesday. The forecast for early 2023 was 4,050, 15% lower than the level at the end of the year for the S&P 500.

As of Friday, bond market volatility measured by the ICE BofAML MOVE index remained near its highest level this year. The question now looming is whether the United States is entering a new phase in which inflation could be beyond the Fed's control, especially as the country shifts to a more closed trade policy and fails to control its nearly $35.7 trillion national debt and a budget deficit of about $1.9 trillion.

Eric Vanraes, head of fixed income at Eric Sturdza Investments, said the U.S. debt burden is “unsustainable” and “rising.” The firm managed $1.2 billion in assets as of May. “A possible Trump win and competition from more attractive bond strategies is not a positive for long-term bonds,” Vanraes said. “Trump's plans are expected to weigh on long-term rates by adding a little inflation. However, if Trump wins the presidential election and the Democrats control Congress, his plans will not be fully realized. For the market, who controls the House and Senate is as important or more important to long-term yields as who wins the presidential election,” Vanraes wrote in an email.

“There was a lull of globalization, friendly trade policies and accommodative policies for nearly 15 years,” Luo said. “Now, as we come out of years of accommodative environments and witness the retrenchment of globalization/repatriation and generally more closed policies, we are in a much more complex environment.” In addition to growing inflation anxiety, there is also a greater focus on the so-called “neutral” interest rate, a theoretical rate level that neither stimulates nor restricts the economy. This neutral rate may be higher than generally expected, raising concerns that the Fed could spur another wave of inflation if it cuts borrowing costs too much.

“have both proposed fiscal policies that could add to already strained debt and deficit conditions and increase inflationary pressures. Therefore, the outcome of the U.S. election, including the makeup of Congress after the election, may play a greater role than before in shaping the long-term inflation path as well as the nation's fiscal position.” Saglimbene believes that “investors are more confident that inflationary pressures will ease in the short term, while also seeing more resistance to long-term inflationary relief. This interplay between short-term and long-term inflation may be one reason why 2-year and 10-year Treasury yields have moved higher recently despite expectations of further rate cuts from the Federal Reserve.”

In summary, the dual challenges of the strong rebound of the US stock market and inflation risk have put forward higher requirements for investors and strategists. While they need to remain optimistic about the market's rise, they must also be wary of the uncertainties that inflation risks may bring.