Wall St embraces Goldilocks fairytale

The Dow Jones has surged 4 per cent in the past fortnight with Wall St believing the Fed has won the battle over inflation. But it might be too early to call it a fairytale ending.

Wall St has decided that the battle over inflation in America is over and that the Fed has won.

Furthermore, and this is the really important bit, Wall St has decided that the battle – using of course higher interest rates – has been won without choking corporate profits. Or for that matter, crushing wages.

That’s to say, it’s been the ultimate Goldilocks win-win-win – for consumers, for companies, for wage earners.

Since the latest US CPI inflation number was released two weeks ago, Wall St has risen almost every day,

The Dow has gone up 4 per cent, to be now just 3 per cent below its post-Covid (and all-time) high of December 2021 – just before, of course, the Fed started hiking rates from zero.

Those rate hikes were designed to crush inflation.

The latest CPI data showed inflation back to 3 per cent in the year to June. That’s still above the Fed ‘target’ of 2 per cent – as contrasted with our ‘2-3 per cent’.

But Wall St has essentially decided ‘battle over’; no or at least perhaps only one more rate hike; soon, the start of rate cuts; and all, critically, without much damage to corporate profits.

So far, the profits rolling out in this latest US quarterly reporting season are confirming that; as I wrote, the ’Goldilocks outcome’.

Now, as I also wrote two weeks ago, the confirmed big drop in US inflation – which had actually been hiding in plain sight all year - was unambiguously a good news story.

Not just for the US generally and for Wall St in particular, but for the entire world.

But, I’ve now also got to ‘rain on that parade.’

People work on the floor at the New York Stock Exchange. Wall St has rallied over the past two weeks. (Photo by ANGELA WEISS / AFP)

There are three cautions.

First, while overall US inflation has fallen to 3 per cent, services inflation remains stickily higher around 5 per cent.

Yes, the Fed might stop hiking or deliver only one more hike – we’ll get a better sense, with the latest policy announcement early Thursday morning downunder time.

But it might well keep rates higher for longer than Wall St assumes because of that sticky inflation.

Further, even the overall 3 per cent is not 2 per cent; and it mightn’t get anywhere near 2 per cent anytime soon because of all the factors, many flowing from the Covid era, keeping inflation sticky.

The third big factor is that the strong rise in US corporate profits is essentially a mirage.

First, because of the comparison factor: it’s compared with the year to June 2022, when the Covid negatives were still playing out.

And second, because these profits are still essentially ‘pre-rate rise’ and ‘Covid-assisted’ profits.

The Fed started hiking in March last year. It was only by the end of the year that the Fed had got some way away from ‘free money’ and the eternal optimism of the Wall St punter that it wouldn’t really get serious.

Let’s see how both the overall US economy and US corporate profits go in a sustained world of real Fed rates, with its policy rate above the inflation rate.

In sum and in short, I doubt this level of the US market is sustainable into 2024.

Originally published as Wall St embraces Goldilocks fairytale