The S&P 500's Rally Amid Light Inflation Data: A New Bullish Regime?

The S&P 500's October 2023 rally, fueled by September inflation data showing moderation in price pressures, has sparked debates about whether this marks the start of a new bullish regime or a temporary reprieve. With the Federal Reserve's preferred inflation gauge-the core Personal Consumption Expenditures (PCE) index-rising 0.3% monthly in September and 3.7% year-over-year, markets have priced in a growing likelihood of rate cuts in 2024. This shift in policy expectations, combined with evolving investor psychology, has reshaped risk appetite and asset allocation strategies. However, the sustainability of this rally hinges on the interplay between inflation resilience, labor market dynamics, and the Fed's policy credibility.

Inflation Moderation and Policy Pivots

September's PCE data, at 3.4% year-over-year, marked a slight improvement from August but remained above the Fed's 2% target. Core PCE, which excludes volatile food and energy, rose 0.3% monthly, underscoring persistent services inflation-a key concern for policymakers. Meanwhile, the Consumer Price Index (CPI) showed a 0.4% monthly increase, with core CPI cooling to 4.3% annually. The divergence between PCE and CPI, driven by differing methodologies (e.g., PCE's lower housing weight), highlights the Fed's focus on a broader, more stable measure of inflation.

The Cleveland Fed's nowcasting model, which integrates high-frequency data like oil prices, reinforced expectations of a soft landing, with inflation trending closer to the Fed's target. This data, coupled with a flattening labor market, unemployment rose to 4.3% in August, prompted the Fed to cut rates in September-a nine-month pause in tightening-signaling a policy pivot toward growth support.

Market Psychology and Investor Positioning

The S&P 500's October rally reflected a shift in investor psychology from "higher for longer" rate fears to optimism about near-term easing. Futures markets priced in a 97% probability of a September rate pause and a 61% chance of a November pause, while equity indices surged as traders anticipated a December cut. Equity indices surged as traders anticipated a December cut, megacap stocks like Tesla and Microsoft led gains, while sectors sensitive to rate cuts-such as real estate and utilities-also outperformed.

However, this optimism was tempered by caution. Services inflation, which accounts for 60% of the U.S. economy, showed limited progress, and oil prices hitting 2023 highs added inflationary risks. As a result, investor positioning remained mixed: while equities rallied, bond yields climbed to cycle highs, reflecting uncertainty about the Fed's ability to engineer a soft landing.

Sustainability of the Rally: A Delicate Balance

The question of sustainability hinges on three factors: inflation's trajectory, labor market resilience, and the Fed's credibility. Vanguard analysts project headline inflation will end 2023 at 3.2%, with core PCE at 3.6%, suggesting a gradual disinflation path. However, the "higher for longer" narrative persists, with the Fed emphasizing that rates will remain elevated until inflation is "firmly" back to target. This duality has created a "Goldilocks" scenario: Q2 GDP expanded 3.8% annually, but risks of a prolonged high-rate environment linger.

Expert analysis from BNP Paribas and Ofi Invest underscores the fragility of this balance. While the Fed and ECB are expected to pause further hikes, the path to rate cuts remains contingent on services inflation cooling and labor market slack increasing. A "soft landing" scenario, where growth continues without a recession, is now the base case for many forecasters, but geopolitical tensions and energy shocks could disrupt this trajectory.

Strategic Implications for Asset Allocation

For equities, the rally's sustainability depends on active stock selection. Growth sectors, particularly those benefiting from rate cuts (e.g., tech, renewables), are likely to outperform, while value sectors may lag if inflation surprises persist. Fixed-income markets, meanwhile, face a dual challenge: long-term rates are near cycle highs due to elevated bond supply and inflation hedging demand. BNP Paribas recommends U.S. Treasuries (maturities up to 10 years) and inflation-linked bonds (TIPS) as defensive plays, while cautioning against overexposure to high-yield corporate debt amid economic slowdown risks.

Conclusion: A Bullish Regime with Caveats

The S&P 500's rally in late 2023 reflects a recalibration of market psychology toward optimism about Fed easing and a soft landing. However, this bullish regime is not without risks. Persistent services inflation, geopolitical volatility, and the Fed's "higher for longer" stance could reintroduce volatility. For now, the data supports a cautiously optimistic outlook, but investors must remain agile, balancing equity exposure with defensive fixed-income allocations to navigate the uncertain path ahead.