Investor fears of an economic slowdown are fading fast, fueling a recovery that is boosting riskier asset classes, especially the “fear of missing out” that dominated equity markets before the strong resurgence of the massive sale last year.
The US S&P 500 stock index is up 8% year-to-date and the Nasdaq Composite, which is weighted by US tech giants, is up 16%. They were respectively down a fifth and a third last year.
Friday’s U.S. jobs report helped bolster investor confidence in the strength of the U.S. economy, despite the risk it could prompt the U.S. Federal Reserve to maintain tighter monetary policy for longer as it is trying to control persistently high inflation. Markets closed the week despite falling after the release of the jobs report.
“Markets are pricing in the end of the inflation problem and . . . very heavily discounting the risk of an extreme event,” Nitin Saksena, head of U.S. equity derivatives research at Bank of America, said. reference to improbable but high-impact events that are difficult to model.
“The risk of a severe recession, a policy mistake or a second wave of inflation becomes an afterthought,” he said.
Cboe’s Vix index, which tracks investors’ expectations for volatility over the next month and is often referred to as Wall Street’s “fear gauge”, has plunged since the start of the year. It has been below its long-term average of 20 for two consecutive weeks, the longest period of low volatility since the start of last year.
The one-year Vix, which tracks expectations of stock market fluctuations over the next year, touched its lowest level since the start of the coronavirus pandemic this week.
“That tells you there’s a very strong reassessment going forward, not just next month,” Saksena said.
Assets that were among the most beaten in last year’s sale are now the best performers. Bitcoin jumped more than 40%, while Cathy Wood’s ARK Innovation fund, which is dominated by high-growth tech stocks, rose 46%.
Analysts and investors at major banks and asset managers such as Morgan Stanley, UBS and BlackRock have repeatedly argued markets are too optimistic, but stocks have so far largely ignored weak earnings results. businesses in the fourth quarter. This despite the fact that the S&P 500 is on track to report its first year-over-year earnings decline since the peak of the pandemic.
They also ignored the Fed’s insistence on keeping interest rates high for a long time rather than quickly swing into cuts.
The sudden improvement in the global economic outlook reinforced the argument of the optimists. As recently as the beginning of this year, the IMF warned that a third of the world was facing a recession; but this week he raised his forecast and said the world was “a long way off [sign of] global recession”.
Investors are increasingly convinced that the Fed can control inflation without causing a major recession.
On several occasions last year, Fed Chairman Jay Powell helped end similar stock market rallies by warning that the central bank did not want financial conditions to ease too soon. This week, however, he seemed relaxed about recent gains, noting that “we’re not focusing on short-term moves” and saying for the first time that “the disinflationary process has begun.”
The magnitude of the rally was exacerbated by factors ranging from timing to investor psychology.
For some hedge funds and quantitative investors, a drop in the Vix has a mechanical effect on risk calculations that causes them to increase leverage and gain exposure to equities. For many wealth managers, the tax incentives created additional selling pressure in December and the opportunity for good business in the new year.
“If you had something you were considering getting out of, December was the time to do it,” said Randy Frederick, managing director of trading and derivatives at Charles Schwab. “Once those tax-loss harvesting opportunities go away, people have money to spend and the ability to buy everything at 20% off.”
Once prices start to rise, it becomes increasingly difficult for other investors to resist, even if their view of the economic outlook has not fundamentally changed.
Mike Lewis, head of US equities cash trading at Barclays, said: “There is a lot of money in store after last year and that creates a conundrum. [for investors] — people don’t want to miss a rally. . . you get some FOMO [fear of missing out].”
Lewis said the recent outperformance of assets such as loss-making tech stocks is “not what sustainable rallies are made of,” but there were few obvious events on the horizon that could trigger a reversal.
Yet even some optimists believe the magnitude of the rally has become extreme.
Jonathan Golub, chief US market strategist at Credit Suisse, said there were “many reasons to build a positive narrative, and I think the bears are unaware that there’s a lot of good news” but “the market is behaving as if we’re on the other side of a recession that hasn’t even happened yet”.
Lewis suggested that economic data would be more important than comments from the Fed in changing investors’ minds on the outlook for interest rates – but that could take several months.
“What could create a risk hiccup is if we don’t start to see a loosening of the labor market [by the time] we are approaching summer,” he said. “It could lead to a tough second half, but it’s a long way off.”
