Currently, it seems that only politics — especially the policy implications of Donald Trump's imminent return to the White House — is driving the market's direction. But be prepared for a reality check.
This week's labor market data, especially the key November employment report due out on Friday, has significant implications for the Fed's rate cut plans. This will be crucial for stock market investors, bond traders, and everyone participating in the financial markets.
"I think the market wants to see some positive outcomes, but not too positive," said Brent Schutte, Chief Investment Officer at Northwestern Mutual Wealth Management Company, in an interview.
"If the data is extremely positive, it will raise questions about whether the Fed will actually cut rates," Schutte added.
This could be a problem for the stock market, as current stock valuations are already at historical highs. The optimistic expectation for a continued bull market into 2025 partly relies on the Fed cutting rates, which would help lower market rates and make these valuations more attractive. High rates make it difficult to justify high valuations as they reduce the present value of future profits and cash flows.
Schutte's views on valuation and the Fed may resonate with investors familiar with or who have experienced recent stock market history.
As Nicholas Colas, co-founder of DataTrek Research, observed last week in a report: "Readers from certain eras will remember how the internet bubble of the 1990s ended in the first quarter of 2000, when the Fed clearly stated they would raise short-term rates to over 6% from the mid-1990s."
Colas stated that the reason for the bubble's burst was that neither stock valuations nor investor sentiment were prepared for the Fed's signals, or for rate hikes that pushed the federal funds rate to 6.5%.
"Yes, although this is just a small amount of rate hikes, it conveys the signal that the Fed wants to slow down the U.S. economy. This is enough to cool down the market's speculative sentiment, and it cools down very sharply," he said, noting that DataTrek does not expect a similar situation to occur and remains optimistic about the stock market outlook.
According to the CME FedWatch tool, federal funds futures traders expect the Fed to cut rates by 25 basis points (a quarter of a percentage point) next month, indicating further expected cuts following the half-point cut in September and the quarter-point cut earlier this month. Last week, the personal consumption expenditures index for October (the Fed's preferred inflation gauge) rose slightly but in line with economists' expectations, further strengthening these expectations.
The Fed used concerns about further deterioration in the labor market to justify the aggressive rate cuts when it initiated the monetary easing cycle in September. Fed Chair Jerome Powell clearly expressed his stance against further deterioration in the labor market during his speech at last year's Jackson Hole conference.
Regarding the Federal Reserve, the minutes from last week's November meeting revealed that there is uncertainty around the neutral policy rate — the level at which the Fed's policy rate neither stimulates nor slows down the economy — leading participants to advocate for a more 'gradual' pace of rate cuts.
One issue facing the Fed is that when the current inflation data is plugged into the Taylor Rule (a formula used by economists to measure what interest rates should be set based on inflation levels and economic growth), the result indicates that the federal funds rate should remain at its current level, stated Steve Blitz, Chief U.S. Economist at TS Lombard, in a report last week.
"While I believe the Fed still leans toward rate cuts, the employment data for November is crucial for this data-dependent Fed committee," he wrote.
Meanwhile, the stock market is entering December with strong momentum. The S&P 500 rose 1.1% in the week following the Thanksgiving holiday, achieving its 53rd record close, up 26.5% year-to-date. The Dow Jones Industrial Average briefly broke through the 45,000-point mark and set a new record, while the Nasdaq Composite recorded a monthly gain of over 6%.
In this week's shortened holiday trading, U.S. Treasury yields provided some comfort to stock market investors, with the 10-year Treasury yield falling nearly 22 basis points to 4.192%, the lowest level since October 21. Previously, the yield had briefly exceeded 4.5%, rising from about 3.6% at the end of September.
As the bull market continues to rise, fueled by post-election excitement and optimistic seasonal factors, the short-term risk may be that investors' optimism about the market outlook is overly inflated.
The consumer confidence index survey for November released last week showed that expectations for a rising stock market over the next 12 months reached a historical high, noted Ed Yardeni, an economist at Yardeni Research, in a report.
"If Americans seem to reach a consensus on something, it's that the stock market will continue to rise... From a contrarian investment perspective, this suggests a pullback may occur," he said.
Returning to the fundamentals, the economic data and the rise in the post-election market are not as disconnected as they may appear externally.
"What the market is focused on is real political change, not just politics," said Lauren Goodwin, economist and chief market strategist at New York Life Investment Company, in an interview. "In other words, we believe that more durable investments are those trades supported by broad economic themes."
Trump's victory led investors to expect an acceleration in economic growth, partly due to anticipation of tax cuts and deregulation, driving the stock market up. It also sparked concerns about a resurgence of inflation, pushing bond yields higher. However, it should be noted that these market reactions occurred against a backdrop of strong economic data and slightly above-expectation inflation figures, which investors were anticipating.
As Paul Christopher of Wells Fargo Investment Institute told MarketWatch shortly after Election Day, Trump's policies "are moving toward the mainstream trend." This week's employment data could impact this trend.
Article reposted from: Jin Shi Data
