Macroscope | Four reasons the global market rally should be viewed with caution

The ferocity of the rally in financial markets over the past few months has been striking, despite persistent vulnerabilities and risks in the global economy

While there are plausible reasons for the surge in optimism, high inflation in key economies and the possibility of a sharp downturn pose significant risks

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A trader works on the floor of the New York Stock Exchange on July 26, as a screen displays a news conference by US Federal Reserve chairman Jerome Powell following the Fed rate announcement. Photo: Reuters

Published: 10:30pm, 3 Aug 2023Updated: 1:12am, 4 Aug 2023

If investors knew at the end of 2022 that, halfway through this year, global manufacturing activity would still be in contraction territory, US interest rates would be above 5 per cent, China’s post-Covid recovery would stall and leading central banks would be considering increasing borrowing costs further, would any fund manager have predicted that global stocks would be up 14 per cent this year?

That financial markets and the real economy often diverge, sometimes spectacularly so, should come as no surprise. What is striking, however, is the ferocity of the rally in the past few months in the face of persistent vulnerabilities and risks in the global economy.

The technology-heavy Nasdaq Composite index is up a staggering 33 per cent this year while spreads on US high-yield bonds have fallen to levels that precede the Federal Reserve’s decision in May last year to start raising rates aggressively.

There are several plausible explanations for the surge in optimism in markets. The most common one is that investors are increasingly confident the Fed can engineer a “soft landing” for the US economy by tightening monetary policy sufficiently to quell inflation without causing a recession.

In June, headline inflation fell to 3 per cent year on year, down from around 9 per cent a year ago. Moreover, the labour market remains remarkably resilient, with unemployment standing at a mere 3.6 per cent.

Another oft-cited reason is the euphoria around generative artificial intelligence (AI) following the release of ChatGPT, the most popular AI chatbot, last November. Many investors believe the consumer-friendly technology will unleash a productivity boom akin to the rapid growth of the internet.