This year’s stock market rally has been “very narrow” and may not be sustainable, according to Seema Shah, chief global strategist at Principal Asset Management.
U.S. stocks rose sharply Thursday, bringing the S&P 500 index’s gains this year to 7.7% despite a slowing economy, according to FactSet data. The U.S. economy expanded at a soft 1.1% annual pace in the first quarter, slower than Wall Street analysts’ forecast for 2% growth in gross domestic product.
Big tech companies are propelling the S&P 500’s rise in 2023, with shares of Facebook parent Meta Platforms Inc. META,
This stock market seems to be expecting both that the U.S. can avoid a recession and that the Federal Reserve will later this year pivot from its interest-rate hiking campaign and begin cutting interest rates, Shah said in an interview Thursday. But the Fed tends to cut rates because of a recession or a crisis, she said, which probably wouldn’t bode well for equities.
That amounts to a “disconnect that can’t be sustained for very long,” in her view.
Shah said she is “underweight” U.S. equities and is expecting a recession later this year, although an “imminent” contraction in the next three months is “very unlikely.” While the U.S. economy slowed in the first quarter, the labor market is “still fairly solid,” she said, which adds to inflation pressures the Fed has been battling for the past year with rate hikes.
Read: A much predicted U.S. recession still hasn’t happened thanks to consumers
Also see: U.S. jobless claims fall sharply in latest week
The Fed will probably raise its benchmark rate by a quarter percentage point at its policy meeting next week, according to Shah, which is in line with market expectations. But she sees a “higher risk of a June hike than the market is currently pricing in” as the economy, at least for now, remains “fairly robust.”
In her view, the Fed won’t cut rates this year unless “significant systemic problems” emerge, as it will probably be focused on keeping inflation from reigniting. While the cost of living has fallen from last year’s peak, inflation remains elevated and is well above the Fed’s 2% target.
See: Inflation is still stubbornly high, CPI shows, but prices are rising more slowly
Data from the consumer-price index showed the core rate of inflation, which omits food and energy prices, was up 5.6% on a year-over-year basis in March.
Meanwhile, fed-funds futures show traders largely expect the central bank will next week lift its benchmark rate by a quarter point to a target range of 5% to 5.25%. Traders see a 67.2% chance of the Fed pausing its rate hikes at its policy meeting in June, versus a 24% probability of another rate hike, according to CME FedWatch Tool, at last check. And by the end of the year, traders are expecting Fed rate cuts.
Read: Could the Fed pause next week? It’s not out of the question.
Shah expects the Fed’s aggressive series of rate hikes over the past year will eventually soften the labor market and lead to a U.S. recession. Meanwhile, she’s paying close attention to lending activity on concern that it may slow due to last month’s regional-bank trouble.
Regional banks are significant employers in the U.S. while also providing around 30% of its lending activity, she said. The failure of Silicon Valley Bank in March may make regional banks more selective when providing loans, she said, a pullback that would slow the economy.
“Once you start to see job losses, it tends to spiral fairly quickly,” she said. The U.S. unemployment rate of 3.5% is currently around historic lows, but once it ticks up by around 0.5% it will probably accelerate higher and lead to a recession, according to Shah.
While Shah is underweight U.S. equities, she said that within the U.S. stock market she is overweight megacap companies, partly on the expectation that their significant international revenues will help shield them from a slowdown in the U.S.
Read: Why the broader U.S. stock market has ‘a lot riding’ on Big Tech earnings
U.S. stocks finished sharply higher Thursday, with the S&P 500 SPX,