Relentless U.S. stock rally faces Fed test

By David Randall

NEW YORK (Reuters) – A U.S. stocks rally faces a potential inflection point next week as the Federal Reserve is expected to deliver what may be the final rate hike of its most aggressive monetary policy tightening cycle in decades.

As the year began, many investors expected higher interest rates to bring on a recession that would further hurt stocks after 2022’s sharp decline. Instead, the U.S. economy is proving resilient even as the Fed has made progress in its inflation fight – an ideal “Goldilocks scenario” that many believe will support equities. The is up nearly 19% year-to-date and closed on Thursday at 4,534.87, only about 6% below an all-time high reached in January 2022.

While investors broadly anticipate the central bank will raise rates by 25 basis points at its July 26 meeting, many also hope for signs that policymakers are more confident inflation will continue cooling, eliminating the need for the Fed to lift borrowing costs much further and supporting the thesis that has helped buoy stocks in recent weeks.

“A big part of the market is still macro driven and inflation is still in the driver’s seat. What the Fed does and says next week will be critical,” said Cliff Corso, chief investment officer at Advisors Asset Management.

Expectations of a benign macroeconomic backdrop and an end to Fed tightening have pushed some analysts to revise views on how high stocks will go this year.

Jonathan Golub of Credit Suisse on Tuesday raised his year-end target on the S&P 500 to 4,700 from 4,050, citing a stronger economic outlook and expectations of strong technology and communication service earnings.

Fundstrat Global Advisors’ Tom Lee raised his year-end target to 4,825 earlier this month, while Ed Yardeni of Yardeni Research sees the S&P 500 at 5,400 in the next 18 months.

Meanwhile, a gauge tracked by the National Association of Active Investment Managers showed stock pickers’ exposure to equities at its highest since November 2021, months before the Fed began its rate hiking cycle.

“Bearish investors have had to capitulate,” said Liz Ann Sonders, chief investment strategist at Charles Schwab (NYSE:). “We’re seeing a fundamental backdrop of lower inflation, resilient economic data, better consumer confidence, and a falling dollar that’s a pretty good recipe for gains.”

Eric Freedman, chief investment officer at U.S. Bank Wealth Management, has increased his stock holdings in recent months and is growing more bullish on the tech sector in anticipation that companies’ earnings will improve as the economy remains resilient.

“Consumers have been aided by a tight jobs market and some solid real wage gains, and at the same time we’re seeing some real progress on the inflation front,” he said.

At the same time, forecasts for a recession – seen as all but a foregone conclusion at the beginning of the year – are growing less dire.

Goldman Sachs (NYSE:) on Monday cut its probability of a U.S recession starting in the next 12 months to 20% from an earlier 25% forecast, positing that easing inflation could open a path for the Fed to lower rates without precipitating a downturn. The bank last month raised its year-end S&P 500 target to 4,500, from 4,000.

Yet many strategists remain bearish, wary of shortfalls during the ongoing earnings season to surprises in the durability of inflation.

Sunitha Thomas, senior portfolio manager at Northern Trust (NASDAQ:), believes inflation will prove more stubborn than expected and has cut exposure to equities in recent months.

“We’ve been telling clients that the market has had a very good run for some very good reasons, but now it’s a good time to rebalance,” she said.

Rising valuations have been another concern, with the S&P 500 now trading at 20.8 times forward earnings, from around 16 times at the start of the year.

However, Christopher Tsai, chief investment officer at Tsai Capital, is not worried about buying into an overvalued market. He has added eight companies to his portfolio this year, including index provider MSCI Inc and animal health company Zoetis Inc (NYSE:), that he believes have been overlooked in the market’s advance.

“It’s hard to find names that are massively overvalued,” he said.

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