Evidence suggests that this year’s risk asset rally is likely primed for a pullback.

So now, why now?

Why the glum news after the S&P 500 index posted one of its strongest year-to-date gains in a while?

Well, it’s essential to remember that most market activity is underpinned by a narrative or a story that influences price swings either higher or lower.

And this year’s rally isn’t any different.

To be sure, the consensus view among many investors this year was that the Federal Reserve (the Fed) would finally beat inflation by aggressively raising interest rates.

And, while higher rates are typically a market headwind, investors bet that the Fed’s aggressive moves would eventually tip the economy into a recession, prompting policymakers to reverse course sooner rather than later.

Now, the Fed tends to cut rates to get ahead of rising unemployment, which tends to happen during a recession, and so financial markets interpret falling interest rates as supportive of market prices.

And so, while headline inflation has fallen this year, the long forecasted recession has failed to materialize.

Now, in any other situation, this would be a win for households, businesses, and policymakers alike.

But the fact that the US economy continues to hum along even as it’s now more expensive than ever to borrow money suggests that the fight against inflation isn’t over yet, and the story many investors have been betting on this year likely won’t happen as quickly as once hoped.

Adjusting Market Expectations

To be sure, according to implied Fed Funds futures coming into the start of this year, market participants expected the Fed to take higher throughout the year before eventually cutting Fed Funds to around 4.25% by December.

Now, as of the end of August, with the Fed funds rate sitting around 5.25%, that same futures data now suggests that policymakers will actually keep rates where they’re at now and avoid cutting rates through well into the first half of 2024.

So then, what does this outlook do to the current market narrative?

Well, the truth is that the narrative that had driven asset prices to current levels is likely losing steam, even as higher interest rates have exposed fractures in the regional banking sector, as we discussed some months ago.

Now, what this means is that with interest rates staying higher for longer, there’s more risk that something in the economy or financial system could come undone. But for now, economic and systemic concerns appear measured enough for policymakers to hold tight on current monetary policy.

Supply-side Inflation Normalizing

So then, with all that said, it’s crucial to note that higher rates likely have influenced inflation’s slowing, but the battle isn’t over yet. Indeed, headline inflation, which includes food and energy prices, peaked at around 9 percent last June and has since slowed to 3.3 percent through July of this year.

At the same time, core PCE inflation, which is a better gauge of underlying inflationary pressures, peaked at 5.4 percent in February 2022 and declined to 4.3 percent in July.

So then, from this perspective, falling prices should be good for the economy and the markets, right?

Well, while slowing price growth is indeed a positive market development, the drivers of inflation are different now than they were three years ago. More specifically, it could be argued that the cause of today’s inflation plight started with supply-side drivers and is now being carried along by demand-side momentum.

And what do we mean here?

Well, you likely experienced the full effects of supply-side inflation during the lockdowns when prices shot up at the supermarkets due to a shortage of goods. In fact, the cost of most goods and services started to increase as everything from toiletries to personal protective gear to cars, semiconductors, and appliances were in short supply, ultimately making most everything more expensive.

That’s supply-side inflation, or when prices rise because there’s not enough of something to go around.

You see, when inflation first started taking off in 2021, Fed policymakers and indeed central bankers globally turned a blind eye to the problem, assuming that these price moves would only be temporary or what they call transitory.

In other words, they assumed that once pandemic-era supply chain bottlenecks eased up or more goods were available to go around, prices would eventually return to normal or, at the very least, inflation would slow as more products hit store shelves.

Indeed, after hitting a post-Global Financial Crisis peak in 2021, international shipping costs, as measured by the Baltic Dry Index, are today trading around average levels. What’s more, overland freight shipments tracked by the Cass Freight index show that activity has slowed over the past year, which likely suggests that store shelves are likely being stocked at normal levels again.

So then, if supply-side inflation appears to be normalizing, then what’s the issue?

Changing Inflation Drivers

Well, the concern today isn’t so much about supply-side inflation as it is about demand-side inflation.

Indeed, the pandemic not only exposed the shortage of goods in the economy, it also highlighted the shortage of workers for essential jobs. That’s why, after years of resistance, many firms decided to raise prices to pass along various costs, including the higher wages needed to draw in more workers.

And when you have hundreds of thousands of individuals making 20% more than they were before the pandemic, then you have a recipe for demand-side inflation.

And what is demand-side inflation?

Well, you’ll likely recall that with supply-side inflation, prices rise because there is an equal amount of money chasing fewer available goods.

So then, with demand-side inflation, you have prices taking off because individuals have more money to spend, which means more money chasing after an equal amount of goods and services.

Now, earlier this year, the Fed assumed that it would be able to put a lid on this demand-side inflation by tipping the US economy into a recession through its aggressive monetary policy.

That’s because history has shown that demand-side inflation tends to follow suit when the economy slows as businesses lay off workers and households think twice about spending money.

Hence, wage growth and spending both slow.

And so, coming into the start of this year, market watchers and economists alike were betting on the narrative that slowing growth and the potential for a recession could pull the legs out from under the economy and hence allow the demand side of inflation to finally cool off.

But that doesn’t seem to be the case today.

How come?

Well, that’s because labor market and household spending data, while having softened in recent months, continues to show that the US economy is much more resilient than most had anticipated, prompting many economists to revise higher their year-end US GDP forecasts.

To be sure, this view was solidified by the fact that the Fed’s economists had, for all intents and purposes, stopped projecting a US economic recession.

And even at last week’s Jackson Hole presser, Fed Chair Jay Powell indicated that economic growth has been stronger than expected and, so much so that now there are concerns among policymakers that if this growth trend sticks around, it could put further upward pressure on inflation, which would require more rate hikes heading into 2024, instead of the rate cuts that markets had expected.

Primed for a Pullback

So then, what should we make of this year’s rally?

Should we throw in the towel and move to the sidelines since the narrative seems to be changing?

Well, not so fast.

You see, market narratives evolve and change all the time. They turn on a dime, as they say.

Indeed, that’s where we get the old adage, “buy the rumor, sell the news…”

With that said, adapting to changing plot lines is a way of life for most savvy investors.

And the truth is that we’ve been here before.

In fact, it was precisely this time a year ago that the markets were obsessed with a Fed pivot and were sorely disappointed with Jay Powell’s comments about bringing pain to the economy at last year’s Jackson Hole Symposium.

You’ll also recall that the late summer selloff set the stage for a bull market rally that took hold this year.

Now, make no mistake, we’re not calling for an all-clear or a repeat of last year’s events.

To be sure, persistent demand-side inflationary momentum and shifting market narratives suggest that markets are likely primed for a pullback in the weeks ahead.

Indeed, with the economy still primed to produce higher prices, the prospects of a year-end rate cut have all but faded away, and now, investors are trying to figure out a new story, or a new narrative, to carry the market momentum forward.

And so, history has shown that market volatility tends to pick up when investors are trying to piece together an investment thesis or story they can sell to themselves, to their investment committees, and to their clients.

Indeed, until markets can get a consensus view on a new market narrative, expect more significant day-to-day and week-to-week price swings.

Either way, staying agile, well-informed, and ready to pivot based on evolving circumstances in this market will be essential to taking one step closer to becoming the master of your own financial independence journey.