In the current state of the markets, there may be a sense of uncertainty and even pessimism. However, experts still hold on to the belief that the Federal Reserve will orchestrate a soft landing for the economy, with potential positive implications for the stock market.
Bond Yields Reflecting Fed Actions
Bond yields have seen a significant increase as a result of the Federal Reserve's intentions to maintain high interest rates. This emphasis on higher rates aims to curb demand for goods and services, ultimately aiming to bring inflation back to its targeted 2%. Consequently, the yield on two-year Treasury debt has risen from its summer low of just over 4.6% to around 5.1%.
Interest Rates as a Concern
The stock market is closely monitoring interest rates as they directly impact the overall economy. Since March 2022, the Fed has elevated its target for the fed-funds rate by 5.25 percentage points through a series of 11 moves. Although these increases have already had an impact on growth, the full effects take time to materialize, likely leading to further economic slowdown.
This potential economic downturn could adversely affect corporate profits. Currently, the S&P 500 sits at about 4250, which is roughly 7% below its intraday high in late July, reaching 4607.
The Market's Base Case: A Favorable Outcome
Despite these concerns, investors' prevailing belief, known as the "base case," remains optimistic. The majority of participants in Bank of America's October fund manager survey (64%) expect a soft landing rather than a severe recession resulting from higher rates. In comparison, only 30% anticipate a bleak outcome. It's worth noting that the September survey showed even more confidence in a soft landing, with 74% of respondents expecting this scenario compared to just 21% predicting a recession.
In conclusion, while uncertainty looms in the market, many still hold on to the hope that the Federal Reserve's efforts to combat inflation will lead to a soft landing for the economy. Such an outcome would be welcomed by investors and could provide a much-needed boost to the stock market.
Economic Outlook: A Soft Landing More Likely Than a Hard Landing
The recent shift in the market reflects a small increase in the probability of a hard landing. However, experts believe that a soft landing is currently more likely. Tom Essaye, from Sevens Report, emphasizes that the economy is still growing, albeit at a slightly slower pace. In the second quarter, the U.S. gross domestic product saw an inflation-adjusted growth rate of 2.1%, only marginally lower than the 2.7% recorded in the final quarter of 2022.
This robustness suggests that it would require a significant drop in consumer and business spending for the U.S. to experience a deep contraction. In fact, even if a recession were to occur, it is likely that only slight declines in GDP would be observed.
The positive implications for stocks are evident. With economic growth slowing but nearing its low point, S&P 500 profits have already returned to year-over-year growth for the third quarter earnings reports. If the economy continues on this trajectory, these profits may be sustained beyond this year. Additionally, as inflation declines, there is even a possibility of the Federal Reserve cutting interest rates.
These factors provide a solid foundation for the stock market. Over the past few months, equity buyers have consistently entered the market around the 4200 level on the S&P 500. This trend is likely to continue if investors perceive evidence of a soft landing.
If this scenario unfolds, we can expect the stock market to gradually rise in the near future.
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