A month ago, the S&P 500 seemed to be heading towards an all-time high in a broad-based rally that had raised hopes for further gains this year. But on Friday afternoon, when the index finally cleared the bar, it was being carried by just a few large tech stocks as markets more broadly struggle for direction.
The S&P closed at 4,839.81, eclipsing its previous high from January 2022, a milestone that reflects the widespread belief that the Federal Reserve is on track to successfully bring inflation under control without causing a major recession, executing a so-called soft landing.
But the enthusiasm that drove a rally of almost 16 per cent in the last two months of 2023 has ebbed in the new year. The main Wall Street benchmark has taken three weeks to add another 1.5 per cent, as recent economic data reignited the debate over how soon central banks will start cutting interest rates.
The shaky final stretch to Friday’s record highlights how further gains will rely on the Fed continuing to walk a delicate tightrope.
“That soft landing is a thread-the-needle event that is not easy to do, and that’s why we have very few throughout history,” said Jurrien Timmer, director of global macro at Fidelity, the asset manager. “There are ways that this perfect goldilocks scenario could be upended.”
New economic data had already “taken a bit of the wind out of the sails” of the market, said David Kelly, chief global strategist at JPMorgan Asset Management. “I think the environment is relatively good for stocks but don’t expect a big rally this year.”
A record high for the S&P, he added, was “less meaningful because the momentum that carried us over the finish line [was] weaker”. The tech-concentrated Nasdaq Composite remains below its previous record close.
Most investors say they have not changed their longer-term assumptions of falling interest rates and decent corporate earnings growth, but the new economic figures have been enough to put the brakes on the rally after exuberance got out of hand in the final months of 2023.
“The end-of-the-year rally was a sugar rush,” said Russ Koesterich, global head of investment strategy at BlackRock. “The market had gotten ahead of itself a bit at the end of the year, but the economic data has been resilient and the Fed has talked down some expectations of rate cuts.”
The fourth-quarter rally was driven by optimism that the Fed and its counterparts in Europe were on track to bring inflation back to target levels and could start cutting interest rates as soon as March.
The Fed helped to fuel the optimism last month, with a survey showing officials expected interest rates to be cut three times in the coming year.
But recent data has provided a reminder that inflationary pressures remain — prices rose faster than expectations in December. Jobs growth and retail sales figures this month were both stronger than expected, reducing the pressure on the Fed to cut rates to protect economic growth.
Fed governor Christopher Waller emphasised this point on Tuesday, saying that although the central bank is within “striking distance” of its 2 per cent inflation target, officials would take their time before lowering borrowing costs.
Investors have scaled back bets on an early rate cut, with futures markets now pricing in a roughly 48 per cent chance that the Fed pulls the trigger by March. In December futures traders anticipated a 90 per cent chance of a March cut.
But there is still a strong consensus that the Fed will cut rates substantially this year and the US will avoid a severe recession. Only 17 per cent of investors surveyed by Bank of America this week thought the country would endure a “hard landing”, and only 3 per cent thought borrowing costs would be higher in 12 months’ time.
The yield on the two-year Treasury note, which is particularly sensitive to interest rate expectations, climbed after the latest US inflation data but is still just 0.13 percentage points above where it ended last year. Higher yields reflect lower prices.
Brett Nelson, head of tactical allocation for Goldman Sachs Private Wealth Management, said it would have been unsustainable for the market rally to continue at the same pace after the S&P 500 ended 2023 with nine consecutive weeks of gains. Its near-16 per cent increase over the period put its performance in the 99th percentile of returns over comparable periods, he said.
Nelson added that in the short run, some “indigestion” could lead to the market trading sideways or pulling back. But over the year further gains were likely as “fundamental factors will ultimately prevail”.
The shift in tone has been more pronounced in Europe, however. The continent-wide Stoxx Europe 600 stock index has fallen 2 per cent this month, and investors have scaled back their rate cut expectations further than in the US.
Ronald Temple, chief market strategist at Lazard, said the distinction reflected more severe inflation problems in the UK, and more vocal intervention by central bankers in the eurozone. Senior policymakers have talked down the chances of imminent rate cuts over the past week, including ECB president Christine Lagarde, Bundesbank president Joachim Nagel and Austrian central bank chief Robert Holzmann.
Geopolitical tensions have also added to the more cautious mood on both sides of the Atlantic. Attacks by Yemen-based Houthis on vessels transiting the Red Sea have heightened fears that the war between Israel and Hamas will escalate into a region-wide conflict, as well as feeding inflationary pressures by raising shipping costs.
“One of the fears that has been ever present [since the Israel-Hamas conflict began] was that this conflict would escalate and broaden,” Temple said. “I think geopolitics is going to be harder to ignore.”
Like many other investors, however, Temple said he still expected markets to make decent, if unspectacular, gains through the rest of the year.
JPMorgan’s Kelly said: “When you’re so used to doing very well, when the market goes nowhere it feels like a let-down. I think what we’re really seeing is markets taking a bit of a breather.”