US Stock market indices rebound from March lows, but are equity investors ignoring economic realities?

Historical examples suggest that even when the central bank does manage to land the economy softly, markets often feel a much harder impact.

U.S. Stock market, Equity market, March lows, S&P 500, Nasdaq 100, FED, interest rate,
Recent strength in the equities market may be nothing more than a bear-market rally, fueled by wishful thinking and excess liquidity.

S&P 500 corrected by around 12 per cent while Nasdaq had gone into bear-market territory by falling more than 20 per cent. This was almost a month back in March 2022 but since then, the markets are showing resilience and have bounced back a bit.

S&P 500 has almost recovered from March lows while Nasdaq 100 is still 3 per cent down over the last 1-month period. Will the rebound be sustainable remains to be seen.

On the horizon are some crucial signals that investors are still concerned about. Rising inflation levels leading to increase in yields and two and 10-year rates inverting, the recessionary fears exist.

While the Fed had raised interest rate by 0.25 per cent in March, it has also laid out a clear path for future rate hikes. Globally investors are banking upon the Fed to successfully guide the economy for a ‘soft landing’ without disturbing the markets heavily.

“Recent strength in the equities market may be nothing more than a bear-market rally, fueled by wishful thinking and excess liquidity,” says Lisa Shalett, Chief Investment Officer, Wealth Management.

Morgan Stanley’s Global Investment Committee believes some of the more cautious signals coming from the bond market may better reflect the likely path ahead. Here are the key concerns that they address:

Execution risk is high: Over the past three months, futures markets have gone from pricing three Fed rate hikes to pricing nine, which would raise the benchmark rate to 2.5% later this year and 3.5% next year.

What’s more, minutes from the Fed’s March meeting suggest the central bank may cut up to $95 billion a month from its asset holdings, about $15 billion more than recent consensus expectations.

Such aggressive tightening will make the Fed’s policy execution highly complex, and historical examples suggest that even when the central bank does manage to ‘land the economy softly’, markets often feel a much harder impact.

Rising rates could weigh on equities: Many investors today appear to believe the recent rise in interest rates will be short-lived and that real rates will remain negative, which could support higher stock valuations. This may be wishful thinking. We believe the Fed is apt to tighten policy more than many investors expect, impacting real rates and valuations as a result.

Macroeconomic factors: Macroeconomic headwinds continue to build, and the handful of mega-cap growth names that dominate passive benchmark indices today may not be impervious to such challenges.

Costs for companies, including labor, logistics, distribution, energy and other industrial commodities are rising. Slowing U.S. economic growth, as signaled by declines in new-orders data could pose a challenge. The growing potential of recession in Europe amid the Ukraine-Russia war remains another factor to keep an eye on.

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