- Stocks surged in July despite growing recession fears and dismal economic data.
- The rally was fueled by investors betting that the US economy would collapse and the Fed would cut rates.
- Low rates drive up stock prices, which means bad economic news is actually good for investors.
The economy is shrinking and Americans are increasingly concerned that a recession is on the horizon or already here. Yet the stock market is booming.
The S&P 500 jumped 9.1% in July alone, posting its best monthly gain since the November 2020 post-lockdown rebound. The benchmark is now at the highest level since early June. Other indexes also jumped, signaling that the market pessimism that drove prices down for much of 2022 could turn around.
The rally flies in the face of the economic context. Data released last week showed the economy contracting for a second consecutive quarter, amplifying fears that the United States is heading for a slowdown. Inflation remains at its highest level in four decades. Americans’ financial cushions are rapidly fading and their confidence in the economy is at historic lows.
But all that bad news could have a silver lining for investors: a slowdown could force the Federal Reserve to reverse its fight against inflation and cut interest rates next year, which tends to be a boon. for stocks.
Interest rates play a major role in shaping stock market valuations. Lower rates boost valuations because they allow companies to borrow cheaper. Conversely, higher rates can weigh on the market by intensifying corporate debt burdens and slowing the pace of borrowing.
The Fed has raised rates throughout 2022 in hopes of calming inflation. That pushed stocks lower, but the latest batch of gloomy economic data caused investors to change their bets. Traders now expect growth to slow so much that the Fed will have to put its rate hike plans on hold entirely and cut its benchmark rate to support the economy. These prospects fueled the strong recovery through July.
Admittedly, there is no guarantee that investors will get the rate cuts they are betting on. Fed Chairman Jerome Powell said Wednesday that “it would probably be appropriate” for the central bank to slow its up cycle after raising rates at the fastest rate since the 1980s.
Still, there is plenty of room to slow the pace of the ups before stopping the cycle. The Fed raised rates by 0.75 percentage points at its June and July meetings, tripling the size of its usual hikes.
Fed officials also signaled that they intended to keep raising the benchmark until 2023. Economic projections released after the central bank’s policy meeting in June showed participants expected the fed funds rate to reach 3.4% by the end of 2022. This is up from the current range of 2.25. to 2.5%, which is the equivalent of four more normal quarter-percentage-point hikes at the Fed’s last three meetings this year.
Members then expect the benchmark to reach 3.8% by the end of 2023 before falling back to 3.4% in 2024. This implies some easing throughout the year, but not enough to drive rates low enough to give the economy a big boost.
At a press conference on Wednesday, Powell threw some cold water on investor confidence in the run-up to a short-term rate cut, given how difficult it is currently to guess where the future will go. economy and inflation in the coming months. The Fed’s June estimates are “the best estimate” of what the Fed anticipates, but there is still “so much uncertainty” around the economy’s path, he said.
“You have to take all estimates of what rates will be next year with a grain of salt,” Powell said. “There is now a lot more uncertainty about the way forward than I would normally think, and usually it is quite high.”
Simply put, there is no guarantee that investors will get the lower rates they are hoping for. But as recession fears loom large and signs point to a slowing economy, the odds of a Fed pivot are rising.