Wall Street traders are betting all or nothing on a soft landing for the economy

Bloomberg – From America’s weakest corporate borrowers to the most abandoned neighborhoods in the S&P 500, Wall Street traders are placing new all-or-nothing bets that the US economy will survive Jerome Powell’s war on inflation.

Small-cap stocks just posted their biggest gains versus the broader market since February 2022while a version of the large-cap index that mitigates the influence of giant companies recorded its biggest weekly performance since early summer.

After withdrawing money from it for several months, funds tracking high-yield bonds absorbed nearly $11 billion. Even Cathie Wood’s flagship fund, Ark, is back in fashion.

Underlying this rally is the speculative fever associated with the idea that the Fed can beat inflation without causing a recession. Although evidence of a soft landing increased this week, with a weak consumer price report as well as strength in retail and housing spending, Modern history is full of examples of similar optimism gone wrong.

“It’s a pipe dream,” says Samir Samana of the Wells Fargo Investment Institute. “Or the economy will accelerate again with inflation, prompting the Fed to embark on another round of interest rate hikes, and there will be a harder landing later.. Or the soft landing will quickly turn into a broader and deeper economic slowdown.

The end of interest rate hikes?

Investors are increasingly confident that the central bank has ended its historic tightening campaign and is heading to cut interest rates in the first half of next year. The Russell 2000 index of small companies rose more than 5%, while automakers and banks rose.

According to data from EPFR Global, global equity funds had their second-largest fund inflow this year, which is… The ARK Innovation ETF (ARKK) had its best week of inflows this year, as traders flock to interest rate-sensitive speculative technology stocks.

After three straight months of outflows, junk bond ETFs are on track to have their best month of outflows ever.This is according to data collected by Bloomberg.

This feeds a hope that has emerged repeatedly during Fed Chair Powell’s campaign to rein in consumer prices: that growth can bend, but is unlikely to break as the central bank rolls back stimulus.

Since early November, data on everything from employment to consumer confidence and retail sales have shown the economy losing ground but beating gloomy expectations. S&P 500 earnings for the third quarter are on track to rise about 4%, compared with estimates for a 1% decline a month ago.

However, this is not the first time the euphoria associated with the Fed to encourage gains in economically sensitive sectors has been demonstrated. Macrostrategist’s Deutsche Bank AG, Henry Allen, He points to six instances in the past two years in which the Fed deviated from the accommodative direction that market participants were betting on.

In July last year, for example, a figure showing lower inflation, coupled with Powell’s comments about the pace of increases slowing, boosted sentiment. That helped deliver double-digit gains for the S&P 500 within a month, only for hawkish rhetoric in Jackson Hole to erase the gains.

“Part of my concern is how quickly investors reallocate flows,” said John Porter, chief equity investment officer at Newton Investment Management. “Things that they despised two or three weeks ago, they were now completely committed to. It feels like a very rapid change in emotions.

Technology companies, behind the bullish momentum

Although risk bets have pushed the S&P 500 higher for three straight weeksMost of the progress is the result of gains in technology stocks that have proven resilient to the economic cycle.

Small-cap stocks’ gains remain just a slight uptick on long-term charts, which show a 20% decline since the beginning of last year. While financial companies have stabilized in 2023, the equal-weight S&P 500 has turned positive recently.

Although the moves may be at an early stage, fund managers in general are showing signs of long-term optimism. Nearly 75% of investors surveyed recently said a soft landing is their base case for the global economy in 2024, according to a survey by Bank of America Corp.

Markets are now pricing in interest rate cuts of 92 basis points next year, according to the interest rate swap market.compared to Fed officials’ estimates of a half point of easing by 2024. This threatens negative surprises for those investors prepared for a sharp easing in monetary policy.

“The lesson of the last few years is that all good investors need to be modest in their economic outlook,” said Lindsay Rosner, head of multi-sector fixed income investments at Goldman Sachs Asset Management. “It is better to have a probabilistic view of the world, not one in which a soft landing occurs with 100% probability.”