How the upcoming US inflation data could seal the fate of a highly dodgy rally on Wall Street

A rally in U.S. stocks that has continued despite Wall Street skepticism faces a reality in the week ahead, as key inflation data threatens to close the door on expectations of a dovish change in the Federal Reserve.

The S&P 500 has walked a tightrope this summer, up 13% from its mid-June lows on hopes the Fed will end its market-crushing rate hikes sooner than expected.

A blistering U.S. jobs number on Friday bolstered the case for further Fed rate hikes, but barely rattled stocks — the S&P fell less than 0.2% on the day and achieved its third straight week of gains.

More upside could hinge on whether investors believe the Fed is succeeding in its fight against soaring consumer prices. Signs that inflation remains strong despite a recent decline in commodity prices and a tightening of monetary policy could further weigh on expectations that the central bank will be able to stop raising rates early in the year. next year, drying up risk appetite and driving equities further down.

“We are at the point where consumer price data has reached Super Bowl level importance,” said Michael Antonelli, managing director and market strategist at Baird. “That gives us an indication of what we and the Fed are up against.”

Rebounds in the middle of the 2022 bear market were short-lived, and three previous rebounds in the S&P 500 reversed course to lows, fueling doubts about the duration of the latest rally.

Investors’ bleak outlook was underscored by recent data from BofA Global Research, which showed that the average allocation to equities recommended by U.S. sell-side strategists slipped to its lowest level in more than five years in July, even as the S&P 500 rose 9.1 percent. month for its biggest gain since November 2020.

Institutional investors’ exposure to equities also remained low. The equity positioning of discretionary and systematic investors has remained in the 12th percentile of its range since January 2010, according to Deutsche Bank’s release last week.

For their part, Fed officials last week took issue with the narrative of a so-called dovish pivot, with one – San Francisco Fed President Mary Daly – saying she was “intrigued by bond market prices that reflected investor expectations for the central bank to start cutting rates in the first half of next year.

U.S. rate futures priced a 69% chance of a 75 basis point hike at its September meeting, down from about 41% before the payrolls data. Futures traders also priced in a 3.57% federal funds rate by the end of the year.

Positioning in options markets, meanwhile, shows little evidence that investors are rushing to chase further stock market gains.

The one-month average daily trading volume of U.S.-listed call options, typically used to place bullish bets, was down 3% from June 16, according to data from Trade Alert.

“We are surprised that investors are not starting to chase upside calls for fear of underperforming the market,” said Matthew Tym, head of equity derivatives trading at Cantor Fitzgerald. “People just watch.”

Celia Rodgers Hoopes, portfolio manager at Brandywine Global, believes much of the recent rally has been fueled by short hedging, especially among many high-flying tech names that haven’t performed well this year.

“The market doesn’t want to miss the next rally,” she said. “It’s hard to say whether it’s sustainable or not.”

Of course, investors are not uniformly bearish. Corporate earnings came out stronger than expected for the second quarter, with some 77.5% of S&P 500 companies beating earnings estimates, Refinitiv data showed, fueling some of the market’s gains.

Mr Antonelli also said a weaker-than-expected inflation figure next week could push more investors back to equities.

“Is there a scenario right now where inflation is going down and the Fed isn’t going to stage a hard landing? There could be, and no one is positioned for that.

Others, however, are more skeptical.

Tom Siomades, chief investment officer of AE Wealth Management, believes the market has yet to bottom and urged investors to avoid chasing stocks.

“The market seems to be engaging in wishful thinking,” he said. Investors “ignore the old adage, ‘don’t fight the Fed’.”

Updated: August 07, 2022, 04:30