The Stock Market Has an Inflation Problem. More Losses Could Be Ahead.

The problem is that while economic growth may be softening, it’s still strong enough that it will keep inflation at stubbornly high levels, he says, and that will prevent the Federal Reserve from lowering interest rates. Higher-for-longer interest rates will constrain corporate growth, weigh on demand, and remove one major component of the bull thesis

Another reason inflation is an issue: It makes the recent stock market rally less robust than it appears at first blush, he argues.

“Market performance is grounded in purchasing power, and the narrowly-led S&P 500 adjusted for inflation has remained, in fact, slightly below its level of 2½ years ago (the inflation-adjusted peak occurred Dec. 30, 2021), which we believe is emblematic of underlying problems,” he writes. “To be a ‘secular bull market’ the requirement for over 100 years has been that the S&P 500 continues to make higher highs adjusted for inflation.”

Therefore, the fact that the index hasn’t managed to notch new inflation-adjusted records is a worry for Bannister, especially because history shows that when the S&P 500 transitions out of a secular bull market, it tends to enter a secular bear market.

That situation looks more likely than not, he says. That’s because inflation—which he predicts will remain sticky, if not actually edge higher—will prevent the Fed from lowering rates even as the economy sees sluggish growth, Bannister argues.

The upshot, he says, is the S&P 500 will have to retreat from recent highs. In turn, Bannister is advising investors to shift into industries that are known more for defensive value—like healthcare, consumer staples, and utilities—from the growth-oriented stocks that have driven much of the index’s gains so far.

Bannister has been cautious throughout this year’s rally—though that stance hasn’t been as timely as his calls earlier in 2023. Still, it’s worth noting that other strategists are concerned about the potential for losses—or market volatility this summer at the very least—as high Treasury yields act as a headwind for stocks.

Even those who are relatively optimistic about the market warn that the ride could get bumpier in the months ahead as the market tries to gauge the interest-rate situation. Odds of at least one Fed rate cut by September are hovering around 51%.

“Ambiguity over just how restrictive current Fed policy actually is means there’s high uncertainty over how much the Fed will cut rates this cycle,” notes Jason Draho, head of asset allocation Americas for UBS Global Wealth Management. “Consequently, market calm this summer may be disrupted by a divergence of views on what the Fed will be doing in the summer of 2025.”

So although the market could keep chugging ahead, investors shouldn’t count on Christmas in July.

Write to Teresa Rivas at teresa.rivas@barrons.com