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Wall St Week Ahead - Hopeful US stock rally set for date with Federal Reserve reality

Stocks have repeatedly rebounded from lows on expectations of a so-called Fed pivot, only to be crushed anew

A bounce in US stocks that has defied a barrage of major earnings disappointments faces a key test in the coming week, when the Federal Reserve's next meeting could shed light on how long it will stick to the aggressive monetary policies that have crippled asset prices in 2022.

Betting on a less hawkish Fed has been a dangerous undertaking this year. Stocks have repeatedly rebounded from lows on expectations of a so-called Fed pivot, only to be crushed anew by fresh evidence of persistent inflation or a central bank bent on maintaining its pace of rate increases.

Pockets of softness in the US economy have fuelled recent hopes of a tempering of rate hikes, along with signs that some of the world’s central banks may be nearing the end of their rate hiking cycles. Meanwhile, cash-heavy investors afraid of missing out on a sustained rally have contributed to the bullish move, market participants said.

“The market is starting to believe that there is an endgame in sight for this huge global tightening cycle,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Tech rally

Technology stocks led a broad rally on Wall Street on Friday, capping another strong week for the market, as investors welcomed solid profits from Apple and other companies.

The S&P 500 rose 2.5% and posted its first back-to-back weekly gains since August. The Dow Jones Industrial Average rose 2.6% and the tech-heavy Nasdaq composite climbed 2.9%. Smaller company stocks also gained ground, lifting the Russell 2000 index by 2.3%.

The benchmark index is up over 8% from its most recent low, a move that has been accompanied by a sharp rally in US Treasuries and a weakening of the dollar, reversing trends that have prevailed for most of the year.

A smaller than expected rate increase by the Bank of Canada added to hopes of a peak in global central bank hawkishness, as did comments from a Bank of Mexico board member cautioning against increasing monetary policy to excessively restrictive levels.

While investors have broadly factored in a 75 basis point rate hike on Wednesday at the end of the Fed's two-day meeting, many will be looking for hints of future policy moves in Chairman Jerome Powell’s press conference, as his comments have swayed asset prices this year.

For example, stocks rallied ahead of the Fed's conference in Jackson Hole, Wyoming, in August, only for the market to decline anew after Powell warned about economic fallout from the Fed's efforts to fight inflation.

"If his tone is as terse and as hawkish as it was in August at Jackson Hole, that would certainly change the narrative rather rapidly,” said Art Hogan, chief market strategist at B. Riley Wealth.

Earnings impact

Next week will also test whether stocks can continue to weather disappointing earnings news. More than 150 S&P 500 companies are due to report quarterly results next week, including Eli Lilly, ConocoPhillips and Qualcomm .

Investors will also closely watch next Friday's monthly jobs report for signs of whether the Fed's actions have tempered the labor market.

Plenty of investors believe it’s too early to hope for a slowing of rate hikes. Analysts at UBS Global Wealth Management said the Fed has yet to see evidence of cooling inflation and labor market conditions and that they "continue to think that it is too early to expect the Fed to signal a more dovish stance."

"Conditions for an equity market bottom, including that rate cuts and an economic trough need to be on the horizon, are not yet in place," the UBS analysts said in a note.

Lerner, of Truist, on Friday issued a report downgrading his view on equities to "less attractive" from "neutral" following the rebound. He said that while stocks have become cheaper on an absolute basis this year, "they have actually become more expensive relative to bonds given the sharp rise in interest rates."

For now, however, it appears the bulls are emboldened. One example of investor enthusiasm can be seen in the options market, where the one month average daily volume of S&P 500 puts, typically used for defensive positioning, outnumbers bullish calls by the smallest margin in at least four years, according to Trade Alert data.

"The market is thinking good things," said Kristina Hooper, chief global market strategist at Invesco. "Jay Powell will either confirm that or dispel that next week."