A bull rally in stocks will be unsustainable until the Fed has 'undoubtedly pivoted' from its rate-hike campaign, says UBS

• A durable bull market will likely be elusive until the Fed signals a clear shift away from plans for future rate hikes, says UBS Global Wealth Asset Management.
• Economic growth is slowing but wage growth is still running too hot for the Federal Reserve's liking in a hot inflationary environment.

July's surge in stocks was a bear-market rally, and a durable bull rally is unlikely until the Federal Reserve clearly shifts away from plans for further increases in interest rates, according to a top asset allocator at UBS.

In a note published Wednesday, the Swiss bank addressed a debate in financial markets that followed the Fed's policy meeting last week, with the discussion centered on the central bank's signals on the future of rate hikes. The large majority of investors argued that the Fed "was dovish and effectively pivoted," while the other camp thought Chairman Jerome Powell delivered "the same hawkish message" as last month.

"Differing opinions are a healthy aspect of financial markets, but the quick conclusion reached by those in the dovish camp is a bit surprising," Jason Draho, head of asset allocation in the Americas at UBS Global Wealth Management, said in his note.

The market has become more optimistic that inflation is declining, he said. "The labor market," however, "is still running too hot for the Fed to achieve price stability. If elevated wage growth persists in upcoming payroll reports, hawkish Fed rhetoric is likely to ramp up again."

Investors will get a snapshot of American wages from Friday's nonfarm payrolls report for July. June's report showed average hourly wages rose by 5.1% over the past 12 months. Last week, the Labor Department said its Employment Cost Index for the second-quarter rose 1.3%, faster growth than the 1.2% rate that was widely expected.

The Fed has raised its key interest rate four times this year, to a range of 2.25% to 2.5%. Consumer price inflation stood at 9.1% in June. The fast pace of big rate increases has fueled expectations of inflation cooling as swelling borrowing costs dent demand.

"Slowing economic activity has been a boon to risk assets the past month, as investors anticipated a less hawkish Fed," said Draho. The S&P 500 jumped 9.1% in July, its best monthly performance since November 2020. UBS shared the broad view that July's move was a bear-market rally, corroborated by investor sentiment that remains pessimistic on the macro outlook, among other factors.

"It remains a challenging economic and market environment, and the fundamentals haven't changed enough to expect a different future Fed path today versus a week ago," said Draho. "Until inflation is convincingly falling to acceptable levels and the Fed has undoubtedly pivoted, a new sustained bull market in risk assets is unlikely. "