When we talk of a bear market rally, we are of course referring to US equities. The threat of a bear market rally is centred on the S&P 500, Dow Jones and NASDAQ. These indices contain the worlds largest public companies and are not only a representation of the US economy, but the global economy.
Market commentators tend to focus on the US as a global benchmark and the risks we discuss forthwith are centred on the United States’ leading indices.
The inverse relationship with the pound and overall defensive nature of the FTSE 100 meant London’s leading index avoided a bear market last year. This means the current rally in London’s leading index can’t be categorised as a bear market rally.
A bull or bear market is a move of 20% from peak to trough.
And for the same reasons the FTSE 100 avoided a bear market last year, it’s unlikely the FTSE 100 will enter a bear market this year. The reopening of China and the FTSE 100’s weighting towards China-exposed stocks will likely lead to FTSE 100 outperformance in any period of heightened equity volatility.
US equities
After battling back from the lows of last year, the S&P 500 is now 15% higher than the October low and the NASDAQ is 16% higher. The NASDAQ did very briefly rise above 12,100 in early February, which would have constituted a bull market, but it has since fallen back.
The premise of a bear market rally is that after entering a bear market, stocks rally but a bull market fails to materialise. This risks a revisiting of the lows.
The risk of slowing US economy, stuttering global growth, and Federal Reserve intent on further rate hikes poses a problem for stocks.
Global equities have rallied sharply on hopes slowing inflation is a precursor to lower interest rates. However, market pricing is at odds with recent Fed official suggestions of more 50bps rate hikes and an inflation rate remaining stubbornly high – even if it is receding slightly.
This is the core risk to the current rally.
Even if we start to see economic conditions deteriorating, the Fed must still bring inflation back to 2%. This makes any major u-turn on rates unlikely in the short-term and risks disappointment for equity traders.
Indeed, strategists at Morgan Stanley said stocks have rallied on a Fed pivot that isn’t coming. They also suggest company earnings are starting to suffer which isn’t conducive for higher equity valuations.
Ultimately, the current equity rally suggests investors have disregarded the mantra: ‘don’t fight the Fed’.
“Problematically, equity and credit markets are aggressively fighting the Fed, with valuations only supported by assumptions of ample rate cuts,” wrote Lisa Shalett, Chief Investment Officer, Morgan Stanley Wealth Management in a note to clients.
“History suggests these strategies often end in disappointment as cause and effect are conflated.”
If markets concluded fighting the Fed is futile, there is a chance the current rally reverses and October 2022 lows are revisited.
The equity upside scenario would require lower interest rates, sharp drops in inflation and economic strength.
This Friday’s Non-Farm Payroll will provide the next major instalment of economic data.
