A Once-in-a-Lifetime Wall Street Rally Raises Soft-Landing Concerns

August marked a notable period of resilience for Wall Street, despite the initial turmoil that signaled the worst volatility since the pandemic. By the end of the month, the market demonstrated a renewed sense of confidence in its ability to predict the future, underscored by a striking increase in investor conviction across various asset classes.

‍

A clear example of this optimism is the synchronized rise in exchange-traded funds (ETFs) tracking government debt, corporate credit, and equities, which have all gained ground for four consecutive months. This marks the longest stretch of correlated gains since at least 2007. The S&P 500, in particular, has surged by 25% over the past year, a level of growth that is unprecedented in the lead-up to the first interest-rate cut of a new easing cycle, according to data from Ned Davis Research and Bloomberg that spans seven decades.

‍

Despite lingering concerns about the economy and inflation, and uncertainty about how central bankers will respond, traders are enthusiastically placing their bets. The bond market has already priced in a series of rate cuts, default risk indicators are declining, and the equity market is surging, reflecting strong confidence in a booming economy.

‍

The gains recorded in August, including a 2.3% rise in the S&P 500, a 1.8% increase in an ETF tracking long-dated Treasuries, and a 1.5% boost in investment-grade bonds, highlight the bullish sentiment prevailing across multiple asset classes. Investors are clearly banking on Federal Reserve Chair Jerome Powell to reduce rates in a manner that supports continued economic growth. However, these investments are highly sensitive to upcoming economic data, which will play a crucial role in shaping the Fed’s decisions during its meeting on September 18.

‍

Lindsay Rosner, head of multi-sector investing at Goldman Sachs Asset Management, emphasized the delicate balance required for these optimistic bets to pay off. She noted that continued economic growth, a stable labor market, and sustained consumer spending are all essential elements that must align perfectly for the current market trajectory to hold.

‍

The volatility experienced in early August serves as a reminder of how fragile the current market consensus can be. A single government report on U.S. hiring data for July caused significant market turbulence, pushing the VIX, Wall Street’s fear gauge, above 65. With August’s employment report due in just a week, and economist forecasts for payroll additions ranging from 100,000 to 208,000, the potential for market-moving news remains high.

‍

Next week will also bring data on U.S. manufacturing, durable goods orders, and initial jobless claims, each of which could influence market sentiment at a time when growth has become the primary focus. At the recent Jackson Hole symposium in Wyoming, Powell indicated that while future policy direction is clear, the timing and pace of rate cuts will depend on incoming data, the evolving economic outlook, and the balance of risks.

‍

The Federal Reserve’s dovish stance played a key role in helping Wall Street navigate its summer volatility, with the early August flash crash quickly fading into history. All four major asset ETFs, including those tracking the S&P 500 (SPY), long-dated Treasuries (TLT), investment-grade bonds (LQD), and high-yield bonds (HYG), posted gains of at least 1% for the month. Moreover, over $1 trillion was added to American equities alone.

‍

Traders are currently snapping up everything from small-cap stocks to speculative debt, convinced that the U.S. economy will avoid a consumer-driven downturn, despite signs of a weakening labor market. U.S. equity-focused funds saw inflows of $5.8 billion for a ninth consecutive week, while high-yield funds attracted $1.7 billion, according to data from EPFR Global compiled by Bank of America.

‍

So far, economic data and corporate earnings have not indicated any imminent danger. However, the volatility in August serves as a cautionary tale about the risks of consensus trades, such as those involving long positions in artificial intelligence stocks or bets against the yen, which can suddenly unravel.

‍

The trajectory of interest rate cuts priced into Fed fund futures highlights the uncertainty that still pervades the market. Earlier this year, as inflation fears subsided, bond traders anticipated roughly six rate reductions throughout 2024, with the first expected as early as March. However, as inflation proved more persistent than anticipated, these expectations were scaled back to just one cut by April. Currently, the consensus is that the Fed will initiate its easing cycle next month, with four quarter-point reductions expected by December.

‍

James St. Aubin, chief investment officer at Ocean Park Asset Management, expressed skepticism about these forecasts, noting that both the Fed’s predictions and market expectations are often incorrect. He suggested that while three cuts this year are plausible, four might be excessive unless the economy is in dire straits.

‍

Caution has generally been a losing strategy this year. In the credit market, the much-feared maturity wall—concerns about painful refinancing for corporate borrowers at higher rates—has diminished as the amount of looming debt repayments in the junk bond market is set to decline significantly, marking the biggest annual drop in at least a decade. Credit default swaps, which are used to hedge against credit risks, have also retreated, with the Markit CDX North American High Yield Index hovering near its lowest levels since early 2022.

‍

Interestingly, instead of suffering from higher borrowing costs, corporate earnings may have actually benefited from the rise in benchmark rates from 0% to over 5%. Cash-rich firms, particularly technology giants, have enjoyed a steady stream of income from their bond investments. Analyst Kaixian Tan from Gavekal Research noted that the entire increase in non-financial corporate income since 2022 can be attributed to a drop in net interest payments, a counterintuitive scenario where rising interest income has broadly offset the costs of servicing debt as rates climbed. However, with interest rates expected to decrease, this favorable situation could change, potentially squeezing corporate profits, particularly for large companies with significant cash reserves.

‍

Jack McIntyre, global bond portfolio manager at Brandywine Global Investment Management, cautioned against making definitive predictions in the post-pandemic world, suggesting that economic resilience may wane in the coming year. He believes that in such an environment, bonds could outperform stocks. “To me, a soft landing is just a hard landing postponed,” McIntyre said, expressing doubt that the economy can avoid a downturn entirely.

‍