Why a strong economy makes stock investors nervous

Equity investors realize they are wrong about the Fed.

A strong economy, slowing inflation and hopes that the central bank will stop raising rates sooner than expected have made equity trading nervous.

The S&P 500 lost momentum in February after this week's decline, down 2.4% from its peak in early February. Shares fluctuated between gains and losses as new economic data darkened investors' prospects, marking a notable shift in the market after soaring more than 6% in January.

The change in tone this week came as a steady flow of data has shown the economy continued to run hot in January. Despite high-profile layoffs at big technology firms like Meta and Microsoft, employers in the United States continued to hire at a rapid clip, consumers kept spending and prices continued to rise briskly at the start of the year across an array of goods and services.

All those data points suggest that the economy retains significant vigor, even after a year of rapid policy adjustments aimed at cooling down the economy. Fed officials had repeatedly warned that there was more work to do to slow rising prices, but investors had hoped that a slowdown in inflation that took hold in earnest late last year would allow policymakers to hit pause on their rate adjustments sooner than they had predicted. Now, mounting evidence that the economy remains surprisingly strong and price increases unexpectedly stubborn have begun undercutting that narrative.

In response, investors have sharply raised their expectations for the number of times the Fed will increase interest rates in the coming months. And even central bankers themselves have begun to float the possibility that rates will need to climb higher than they previously expected if the economy does not cool down. Higher interest rates raise costs for consumers and companies, slowing demand and typically weighing on the stock market.

“I’m very negative right now on equities,” said Eric Johnston, the head of equity derivatives at Cantor Fitzgerald, who predicted the recent S&P 500 rally but now expects a slump. “I think the move we have seen in the rate market, some of the inflation numbers that have come out and the expectation that the economy will be fine is all fairly problematic.

Mr. Johnston now believes the S&P 500 will eventually fall below its 2022 lows, more than 10% off current levels. Strategists Morgan Stanley and JP Morgan Chase are also preparing for the fall.

bond investors quickly changed their minds.

Earlier this month, interest rate investors predicted that the Fed would raise the benchmark rate by 0.4 percentage points in March of this year.

But politicians have also hinted that their own estimates could be revised if the economy continues to perform faster than previously expected.

John S. Williams, president of the mighty Federal Reserve Bank of New York, indicated this week that interest rates are likely to rise in the 5% to 5.5% range, slightly above the median range of 5% to 5.25% in December.

He and several of his colleagues have said they may need to do even more than that if consumption and the labor market remain so robust.

“With the strength in the labor market, clearly there’s risks that inflation stays higher for longer than expected or that we might need to raise rates higher than that,” Mr. Williams told reporters in New York this week.

Loretta Mester, the president of the Federal Reserve Bank of Cleveland, said during a speech on Thursday that “we may very well have to move higher, hold it longer at that peak rate or even change what we do at any particular meeting” if economic pressures kept inflation elevated.

Given recent data, economists at Goldman Sachs and Bank of America changed their forecasts on Thursday.

They now expect the Fed to raise rates to 5.25-5.5% this year, a quarter of a point higher than any bank previously expected.

Bank of America's Michael Gapin wrote in a policy note explaining the change, "The Fed may have to raise interest rates unless inflation, job growth and consumer demand moderate."

For investors, the possibility of further rate changes has revived fears that the Fed's campaign will push the economy into recession.

This contrasts sharply with the optimism in financial markets at the beginning of the year that inflation could decline while the economy continues to grow.

David Donabedian, Chief Investment Officer of CIBC Private Wealth US, said at the recent Fed meeting, "We're used to what the Fed told us we would do two weeks ago and we already have to reconsider it." "Market momentum has stalled."