Relief rally faces big tests

This is a very special time for those who believe that if you’ve been good all year, a benevolent snowy-haired man will appear laden with gifts. He’s writing a list, he’s checking it twice (subject to data protection requirements). Yes, Jay Powell is coming to town.

Yet again, markets are in the grip of excitement about the prospect that the Federal Reserve chair will finally deliver the change of heart that investors have yearned for throughout 2022.

Inflation in the US has come slightly off the boil, with the annual rate running at a relatively tame 7.7 per cent in the most recent reading. That might, just maybe, lay the groundwork for the Fed to take a slightly more tentative approach towards raising interest rates. So far this year, it has increased rates at a ferocious pace, laying waste to pretty much every long-only fund manager on the planet.

The only investors left toasting the end of a rip-roaring year are hedge fund managers who have been bullish on the dollar and negative on government bonds. The year-end drinks are on them, with their double-digit returns and slightly smug grins.

For everyone else, this year has been a truly humbling experience, with stocks crumbling and bonds failing to provide the usual counterbalance. But with that slight pullback in inflation helping stocks and other risky markets to recover, Powell added further fuel to the fire this week when he said in a speech to the Brookings Institution that slowing down the pace of rate rises could happen “as soon as the December meeting”. 

Commerzbank described this formulation as “six magic words” that overshadowed all of Powell’s more hawkish utterances at that event. Already, the bank noted, investors had swung towards expecting a half percentage point rate rise on December 14, a step down from the three-quarter-point increments we’ve now seen four times in a row. But now, investors are more confident in that view, and are wondering whether rates might, in fact, fall by the end of next year.

November was, in an otherwise terrible year, actually pretty good. If you had managed to tear your eyes away from the crypto industry train wreck (summary: Sam is sorry), you would have seen gains in everything from stocks and credit to commodities. Deutsche Bank cast an eye across 38 assets and found that 35 of them were up on the month. That is “the highest number so far this year and makes a change from the prevailing mood”. 

The S&P 500 index of big US stocks climbed more than 5 per cent, while Europe’s Stoxx 600 was up almost 7 per cent. Buoyed also by hopes for a softening in China’s zero-Covid strategy, the Hang Seng jumped almost 27 per cent, the biggest ascent since 1998, Deutsche pointed out. Sure, all these stock indices are still way down on the year. Even so, a win’s a win.

Seasonal patterns, at this time of year known as the Santa Rally phenomenon, could help to waft this along further. Skylar Montgomery Koning, an analyst at research house TS Lombard, warns loudly that this year’s Santa Rally narrative has some serious challenges.

“User beware,” she wrote. Still, “psychology plays a role”, she added. “Money managers are judged on annual calendar year performance. Because of the propensity for equities to rally as the end of the year approaches, investors who have lost money have an appetite to chase the rally upwards, while those who have made money are more likely to settle their books.”

Are fundamental investors convinced? “We’re a grinch,” says Michael Kelly, head of multi-asset at PineBridge Investments. “We’re not participating in this bear market rally.” (That’s a no, then.)

Generally conservative long-only fund managers are “playing hedge fund manager”, says Kelly. When the long-anticipated US recession really starts to bite next year and the health of corporate America really starts to deteriorate, stocks will drop back to earth, in his view.

“I’ve never, never seen so many people convinced that someone else is going to keep the market rallying and that they’re going to get out before it all goes wrong,” he adds. “Good luck on that.”

The difficulty, of course, is that bear market rallies look and smell very similar to proper rallies, right up to the point at which they unravel and risky assets start sliding again. We saw that in March, and in July, and it feels like we’re doing it all over again now. It is unusual for fund managers to be as downbeat as they are now even after the MSCI World index of stocks has cranked up 12 per cent in two months. But after the gruelling year investors have had, it is perhaps little wonder some are waiting for something to go horribly wrong before 2023 kicks off.

Others may be heading for a collision with reality, particularly if they underestimate the Fed’s resolve to vanquish inflation, particularly in light of Friday’s robust US employment data. “Recent inflation data triggered euphoria and expectations of a more extravagant Christmas (ie, smaller rate hikes),” wrote Elwin de Groot, Rabobank’s head of macro strategy. “This suggests markets may have to learn the hard way when it turns out that the number of presents under the Christmas tree is not as expected.”

katie.martin@ft.com