The rally over the past month has had a technical tailwind, consisting of short-covering, systematic strategies adding risk, corporate buybacks, and positive retail fund flows. (ddp)

In the US, the NAHB housing index for August also signaled continued weakness.

The S&P 500 is now up more than 17% from its year-to-date low in June, helped over the past week by indications that US inflation is slowing. The headline consumer price index was flat month-over-month in July, and the producer price index fell for the first time since April 2020.

But despite these encouraging signs, we continue to recommend a relatively cautious approach:

While more favorable inflation data takes some pressure off the Fed to hike rates aggressively, talk of a policy pivot is premature. Combining the data from the CPI with the components of the PPI that feed into the Fed’s preferred measure of inflation, core PCE (personal consumption expenditures), suggests only a 0.1% rise in July (vs. 0.3% in May and 0.6%in June).

We have long thought that three months in a row of core PCE at 0.2% or less could be enough evidence of lower inflation for the Fed to consider pausing the rate hiking cycle. But with the labor market still far too tight, we think the cycle is likely to continue even if the inflation data is favorable. We expect the Fed to raise rates by at least 50 basis points at the next FOMC meeting on 21 September, with further hikes likely through the remainder of the year.

The fundamental economic outlook has improved, but slump risks remain. Hopes of a “soft landing” have been reinvigorated by strong jobs data and expectations that most inflation measures are set to continue declining. But it’s also premature to assume that recession risk is now low. The Fed still wants growth to slow to ensure that inflation falls back near the 2% target, and once growth gets to around 1%, the economy is vulnerable to any risk—of which there are many—tipping it into a recession.

Investor sentiment has gone from being very poor in June and July, with investor positioning also being light, to now talk of FOMO (“fear of missing out”) and a Goldilocks outcome. The rally over the past month in particular has had a technical tailwind, consisting of short-covering, systematic strategies adding risk, corporate buybacks, and positive retail fund flows. There’s scope for this tailwind to continue supporting risk markets, as it appears that investors have been either eliminating hedges or starting from low levels of risk, more so than adding significant risk exposures. Improving sentiment over the last two months is a reminder that extreme pessimism is often a good counter-indicator. Bullish sentiment is less predictive of subsequent returns, but investors becoming more optimistic in the current highly uncertain environment does make the markets more vulnerable to negative news.

So, we would caution investors against chasing this rally. We expect renewed market volatility ahead, and we continue to recommend positioning portfolios for resilience under various scenarios. With inflation still high, we favor value stocks including global energy. And with the economic outlook uncertain, we think investors can consider defensive equity exposure via global healthcare or quality income stocks.

Read more in our latest US Regional View and in our recent blog, That was fast (both published 15 August 2022).

Main contributors - Mark Haefele, Jason Draho, Solita Marcelli, Brian Rose, Christopher Swann

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

Original report - Remain cautious despite the equity rally, 16 August 2022.