The stock market still faces 'potential disappointment' on Fed easing bets despite cooling inflation, UBS says

• Investors should still be bracing for a potential stock-market sell-off, according to UBS.
• Inflation cooled again in April, according to Wednesday's Consumer Price Index report.

Stocks are still in a vulnerable position even though there are clear signs that inflation has now started to cool, according to UBS.

Investors may be overly optimistic that the latest Consumer Price Index report means the Federal Reserve will soon end its interest-rate tightening campaign, the Swiss bank warned.

"While inflation is trending in the right direction, we still see potential for disappointment among equity investors on the pace of Fed easing in the remainder of this year," UBS's CIO Mark Haefele said in a research note seen by Insider.

"Inflation is still well above the Fed's comfort zone," he added.

The Bureau of Labor Statistics said Wednesday that the CPI rose 4.9% in April – down from 5% the previous month and way below the forty-year high of over 9% it hit in the middle of last year.

That's a source of optimism for some investors – because they believe that inflation cooling means the Fed will soon wind down the aggressive tightening campaign it began over a year ago in a bid to tame soaring prices.

When interest rates stop rising, stocks tend to benefit because companies can borrow at a fixed rate, boosting the future cash flows that make up a part of their valuations.

The expectation that the Fed will soon pause its tightening campaign, or even start cutting rates, has fueled a broad rally for stocks in 2023, with the benchmark S&P 500 up 8% and the tech-heavy Nasdaq Composite jumping 18% year-to-date.

But Haefele warned that inflation is still far above UBS's 2% target rate – and added that recent hot labor market data means that the central bank can hold rates at a high level without worrying about a surge in unemployment.

"The most recent labor market data looks too hot to justify a further dovish shift in Fed policy," he wrote. "Officials at the May Federal Open Market Committee meeting indicated that rate rises going forward would be data-dependent, with the employment figures a key variable."

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