Wall Street traders are betting all or nothing on a soft landing for the economy

Bloomberg — From the weakest borrowers in corporate America to the abandoned metros of the S&P 500, Wall Street traders are making a new all-or-nothing bet that the U.S. economy will survive Jerome Powell’s war on inflation.

Small-cap stocks have posted their biggest gains against the broader market since February 2022A version of the large-cap benchmark that dilutes the influence of mega-caps posted its biggest weekly performance since the start of the summer.

Funds tracking high-yield bonds have absorbed nearly $11 billion after withdrawing funds from them for months. Cathy Wood’s flagship Ark is also back in style.

Underlying this rebound is a fever of speculation linked to the idea that the Federal Reserve can crack down on inflation without causing a recession. Despite evidence of a soft landing this week, a lower consumer price report and strength in retail spending and housing, Recent history is replete with examples of a similar belief being misplaced.

“It’s a dream come true,” said Sameer Samana of Wells Fargo Investment Institute. “Or the economy will pick up speed again and with inflation, leading the Fed to initiate another round of rate hikes, followed by a hard landing.. Or, the soft landing could quickly turn into a wider and deeper recession.

Fare hike result?

Investors are increasingly confident that the central bank will end its historic tightening campaign and bring interest rate cuts in the first half of next year. The Russell 2000 small-cap index rose more than 5%, while automakers and banks rallied.

Global equity funds had the second largest fund inflows this year, according to data from EPFR Global. ARK Innovation ETF ( ARKK ) had its best week of gains this year, with traders flocking to rate-sensitive speculative tech stocks.

After three straight months of outflows, junk bond ETFs are on track to record their best month of fund inflows.According to data compiled by Bloomberg.

Driving this is a belief that has been repeated during Fed Chair Powell’s campaign to rein in consumer prices: That growth will bend, but it’s unlikely to break even when the Fed acts to undo the stimulus.

Since early November, data on everything from hiring to consumer sentiment to retail sales have depicted an economy losing steam but defying pessimistic forecasts. Third-quarter S&P 500 earnings are on track to rise about 4%, compared with estimates for a 1% drop a month ago.

However, this is not the first time Fed-linked cheer has emerged to spur gains in economically sensitive sectors. Macro strategist Deutsche Bank AG, Henry Allen, The central bank points to six instances in the past two years where market participants deviated from the consistent trend of betting.

In July of last year, for example, a figure showing a drop in inflation, along with Powell’s comments about slowing increases, boosted sentiment. That helped spark a double-digit gain for the S&P 500 over the course of the month, only for a hawkish spree to wipe out gains in Jackson Hole.

“Part of my concern is how quickly investors reallocated the flows,” said John Porter, chief equity investment officer at Newton Investment Management. “Things they despised two or three weeks ago, they are now fully devoted to. It feels like a very quick change in emotion.

Tech companies are behind the curve

Although risk bets have lifted the S&P 500 for three weeks in a rowMuch of the improvement is the result of gains in technology stocks, which have proven resilient to the economic cycle.

Small caps’ gains have been a minor spike in the long-term chart, down 20% since the start of last year. The equal-weighted S&P 500 has recently turned positive, while financials remain flat in 2023.

Although the moves are in their early stages, overall fund managers are showing signs of long-term optimism. According to a Bank of America Corporation survey, 75% of recently surveyed investors said that a soft landing is the primary reason for the global economy in 2024.

Markets are now pricing in 92 basis points of rate cuts next year, according to the Interest Rate Swaps Market.By 2024, central bank officials expect a half-point easing. This threatens negative surprises for investors positioned for a sharp easing of monetary policy.

“The lesson of the past few years is that all good investors should be humble in their economic forecasts,” said Lindsey Rosner, head of multi-sector fixed income investments at Goldman Sachs Asset Management. “It’s good to have a probabilistic view of the world, not one where a soft landing occurs with 100% probability.”