Markets are betting on a soft landing - but the economy is facing 3 hurdles to the ideal outcome

• Markets are pricing in higher odds of a soft landing and Wall Street has pulled back on recession forecasts.
• UBS strategists said the economy and financial markets aren't yet in the clear, however.

The S&P 500 is a few percentage points away from an all-time high, Wall Street is pulling back on doomsday forecasts, and investors think the Federal Reserve is done hiking interest rates.

All of that is leading markets to price in increasingly strong odds the US avoids a recession, but UBS strategists believe the economy still has to clear several obstacles before it can skirt a downturn.

In a report this month, strategists from the bank pointed out that labor market and inflation data suggest a soft landing has become increasingly likely, and that scenario has also been increasingly priced into financial markets.

"We view the increasing popularity of positions associated with more benign economic outcomes, softness in global activity outside the US, and the potential for renewed stickiness in inflationary pressures as three of the key challenges to the soft landing thesis," UBS's Evan Brown and Luke Kawa wrote. "While we are closely monitoring these risks, in our view, these threats to the expansion and market rally are likely to be overcome. Positioning for a soft landing still appears to be an attractive risk-reward proposition."

The first thing hurdle to overcome is equity valuations, specifically the lack of balance between the biggest gainers and everything else. The strategists say a more balanced valuation picture is important for market's soft landing narrative.

While US stocks have rallied over recent months, the gains have been concentrated in a handful of shares, particularly in the tech sector, and those names far outpace the majority of large- and mid-cap stocks, which are more fairly priced.

With second-quarter earnings largely surprising to the upside and companies publishing promising forward guidance, equities could help boost positive real income growth, consumer confidence, and bottom-line outlooks for corporations.

However, that momentum can't steer the economy away from a recession on its own. The second hurdle is economic softness being experienced in places outside the US. Globally, manufacturing and industrial production has stagnated, which could negatively impact the US, according to UBS.

"Traditionally," the strategists said, "more cyclical industries have been leading indicators for where the rest of the economy is going – and if this were to hold true, weakness in the factory sector globally would be expected to bleed through into other parts of the economy – and eventually weigh on the US, as well."

Finally, the bank's outlook for a soft landing requires inflation to cool down — specifically, in nominal spending growth and shelter. Core inflation elements, too, such as airfares, food services, and fuel will be notable details that could move the needle on a downturn.

Any hiccups in the closing months of the Fed's inflation battle could limit the number of rate cuts it could deliver in 2024. Looser or tighter policy, in turn, impacts economic growth.

To the strategists, any residual difficulty in taming inflation "would also likely be associated with enduring resilience in activity – the kind of backdrop in which little monetary policy easing is required to keep the expansion on track and corporate profits moving higher."