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Investors are piling into risky assets in the growing belief that the Federal Reserve and other major central banks are close to winning their battle with inflation, fuelling the biggest rally in global stocks since the early stages of the coronavirus pandemic.
Mounting bets that interest rates in the US and the eurozone have now peaked and are set to be cut in the first half of next year have driven MSCI’s index of global equities almost 9 per cent higher this month. This would mark their best month since November 2020, when news of a breakthrough in the race to evolve a Covid-19 vaccine sent stocks soaring.
In the US, Wall Street’s benchmark S&P 500 index and the technology-dominated Nasdaq Composite are both heading for their best month since July 2022.
Bulls were given encourage encouragement on Thursday when eurozone inflation for November fell to 2.4 per cent, well below forecast and the slowest pace since July 2021, pushing Europe’s Stoxx 600 up 0.5 per cent.
“The market has now latched on to the idea that inflation is no longer a problem,” said Torsten Slok, chief economist at investment firm Apollo. “If inflation is no longer a problem, the Fed is no longer a problem. If the Fed is no longer a problem . . . risky assets should do better.
“The key question,” he added, “is whether that chain of thought is correct”.
Since early last year the Fed has been battling to bring inflation back towards its 2 per cent target. Its most aggressive campaign of interest rate rises in decades was behind a painful bear market in stocks last year.
Rate rises had been a “dark cloud hanging over risk assets”, said Wylie Tollette, chief investment officer at Franklin Templeton Investment Solutions. Higher rates put pressure on stocks by reducing the relative attractiveness of companies’ future earnings and increasing the appeal of safe assets such as government bonds. They also boost costs and default risks for riskier corporate borrowers.
Now, however, “most market participants — ourselves included — believe that the Fed might actually be done” and will succeed in bringing inflation under control without inducing a painful recession, Tollette added.
This week Christopher Waller, one of the Fed’s most hawkish policymakers, said he was “increasingly confident” that monetary policy was in the right place, and that, if inflation continued to fall, “you could then start lowering the policy rate just because inflation’s lower”. Futures markets are pricing in a first quarter-point rate cut by May.
That confidence reflects recent data suggesting price rises are slowing and the job market is cooling, even as overall economic activity remains solid.
The combination paints the picture of “a Goldilocks-type of environment”, according to Tim Murray, multi-asset strategist at T Rowe Price. “We’re not getting a recession, but we’re also not having the economy recover so fast that the Fed has to hit the brakes” to stop inflation returning.
The renewed risk appetite in equity markets has been mirrored in corporate debt markets. Almost $17bn has flooded into corporate bond funds in November, the sharpest monthly inflow since July 2020, according to data group EPFR.
That demand has driven down borrowing costs for the riskiest companies. The average yield on junk-rated debt, as measured by an Ice BofA index, has fallen from 9.5 per cent at the end of October to 8.6 per cent today, its biggest monthly reject since July 2022.
Meanwhile, the Vix volatility index — Wall Street’s so-called fear gauge — is hovering around its lowest level since before the pandemic, in a encourage sign of investors’ optimism.
In Europe, investors are predicting the European Central Bank will start cutting interest rates early next year. But officials have nevertheless been cautious about declaring victory, warning that inflation could rise slightly in the coming months.
The S&P 500 is now just 5 per cent away from its all-time closing high hit at the start of last year, with many analysts and investors predicting it will break through that level in 2024.
However, some in the market are concerned that the rally has run too far. Large asset managers such as Vanguard and Robeco have warned recently that valuations are stretched.
Analysts are pencilling in corporate profit growth of more than 10 per cent next year, but weaker than expected economic growth could hit earnings and knock stock valuations. At the same time, Apollo’s Slok warned that stronger than forecast economic data could also “throw a wrench into the current rally” by reviving fears that the Fed will need to hold rates higher for longer.
“It is premature that the market has been rallying so much,” he said. “We are absolutely not out of the woods.”
