After a seemingly six-month sprint to the mid-year point, it’s understandable for the markets to take a pause. (ddp)

That return could go up or down a couple of percentage points by the end of the week, but I suspect there won’t be a lot of trading activity before we head into what is effectively a four-day weekend in the US due to the 4th of July holiday. It already feels like the markets are taking a breather after a torrid three-week stretch ending in mid-June, during which the S&P rose 7.5%. That run and the entire YTD performance can be chalked up to the economy defying expectations for an imminent recession and instead demonstrating that it could very well achieve a soft landing, a market-friendly development that was turbo-charged by investors catching AI-fever.

So now what?

After a seemingly six-month sprint to the mid-year point, it’s understandable for the markets to take a pause. Indeed, a temporary consolidation phase could be underway as investors enjoy a mini-break and try to figure out what’s the next direction for the markets. They should enjoy the time off while they have it because catalysts for the next direction will arrive almost immediately after the holiday when June economic data begins to be released.

The prospect of a soft-landing, at least in investors' minds, has gone from improbable early in the year to now quite possible. Data that reinforces growth resiliency and disinflation trends could tip that into base case territory. This scenario may happen if June payrolls are in line with or better than consensus forecasts of a 213k increase in jobs, while June headline (core) CPI falls close to 3% (5%) y/y, as expected. In fact, base effects point to headline CPI falling to around 2.5% for July. Even if core inflation is still near 5%, public perception may be that the inflation problem is “solved” with a headline number that low. It's nearly there based on the latest University of Michigan consumer sentiment survey showing 1-year ahead inflation expectations down to 3.3%, its lowest level since March 2021. The Fed and investors may focus on still high core inflation, but perception can become reality for the markets, at least temporarily, and the melt-up could go on.

Of course, this positive market scenario can evaporate quickly if inflation and jobs data disappoint. Or if the Fed does follow through with another 50bps of rate hikes, as Chair Jay Powell said last week during his Congressional appearances. He was just reiterating what the revised “dot plot” implied after the previous week’s FOMC meeting. And just like after the FOMC, the market is still only pricing in one more rate hike this year, and that’s also after other major central banks surprised with hawkish hikes last week. If inflation doesn’t drop sharply in the summer as expected, the markets will have to adjust to a Fed funds rate that’s likely to be even higher for even longer than is currently priced in.

The wildcard in the 2H outlook is AI and whether it can continue to drive the market higher, or at least a handful of mega-cap tech stocks. It’s an idiosyncratic factor because it’s not tethered to macro drivers. Even though AI’s benefits to its users are clearly evident, it’s also more investment speculation than reality at this stage because it’s still early in quantifying the earnings impact across companies, even the few obvious winners. Thus, whether the AI momentum can continue is just a guess.

But a completely unrelated event—the IPO of the fast-casual restaurant chain Cava—suggests that there’s more to this tailwind. Why? Cava’s stock priced popped 80% after its IPO on 14 June. The IPO market has been fallow for the past year and a half, and this market reaction suggests that investor demand for growth stories is very much alive. And nothing offers a more intoxicating growth story right now than a company involved in AI. It will take time for the IPO pipeline of AI-related companies to build, and that means in the meantime investors may continue to bid up any public company that offers a way to play the AI story.

The bottom line: We described the second half outlook as a balancing act, with the Fed, the data, and the AI story all having to go right for equities to go higher, while anything going wrong could lead to a downturn. That balancing act will be put to the test beginning next week. The thing about a balancing act is that there’s usually little margin for error. The inflation and growth data have to thread pretty narrow needles to achieve a soft landing. The two key Messages in Focus of our House View reflect this balancing act: buy quality bonds for their yield and portfolio shield in case that growth needle isn’t threaded, and look for equity laggards because they could pop if both needles come close to being threaded and are already priced for it if not. But for now, enjoy the mid-year halftime.

Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas

Content is a product of the Chief Investment Office (CIO).

Original report – Halftime , 26 June, 2023.