The global rally in stocks that's kicked off 2023 may prove to be 'head fake' as it's too soon to assume inflation is receding, says UBS

• The stock-market rally at the start of 2023 faces risks from still-elevated inflation, UBS Global Wealth Management said.
• Central bankers are monitoring core prices, which rose in the euro area and the US in December.

Stocks worldwide have climbed as 2023 trading gets underway, but downside pressure lies in sticky inflation and strength in labor markets, according to UBS.

Two Federal Reserve officials—St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester–flagged inflation concerns, with their views spurring a slide in US stocks on Wednesday that left the Dow Jones Industrial Average down by more than 600 points.

So far this year, key stock gauges have advanced after sharp losses in 2022. The Euro Stoxx 50 has charged up about 10%, the S&P 500 has gained more than 2%, and China's CSI 300 has surged almost 7%. Investors have been pushing into assets that provide exposure to economic improvement including US small-cap stocks and emerging markets.

Stocks have found support from China's pullback from restrictive COVID-19 prevention measures and from a number of economic reports showing consumer and wholesale inflation retreating from record-high levels.

"But it remains possible that the rally is a 'head fake' and that economic data will ultimately disappoint," Mark Haefele, chief investment officer at UBS Global Wealth Management, wrote in a note to clients Wednesday.

"It remains too early to assume that the inflation threat has fully passed," he said. "The possibility that core inflation is sticker than expected remains a risk for markets."

Both the euro area and the US posted increases in December core prices which exclude food and energy while headline figures showed deceleration. In the euro area, core prices rose 0.7%. In the US, core prices increased by 0.3% as monthly shelter costs drove higher by 0.8%.

Meanwhile, the job markets in Europe and in the US remain strong in terms of hiring and pay growth. Average hourly earnings for American workers in December rose 4.6% year-over-year in December, albeit slower than 4.8% in November.

"We think current demand for labor looks too strong to ensure wage growth slows—which will be essential to bring inflation lower," said Haefele. He noted the three-month rolling average of wage rises was 6.1% last month.

"Such strength is incompatible with meeting the Fed's 2% inflation goal, in our view," he said. "However, a degree of resilience in the labor market should be critical in preventing an economic slowdown turning into a recession, which would be negative for markets," the strategist said.

Bullard and Mester each acknowledged the overall slowing trend of inflation. But they said more interest rate increases to 5% or beyond are needed to drag prices toward the central bank's 2% target. Bullard told The Wall Street Journal he expected the fed funds rate to end at 5.25% and 5.5% in 2023.

Mester in an interview with the Associated Press didn't say how large of a rate hike the Fed should issue for its February 1 decision.

"While the strong start to the year is welcome and we believe more risk-tolerant investors can start to anticipate an inflection point in 2023, we advise against complacency," Haefele wrote. "Economic data remains noisy, making it hard to say for certain that the recent encouraging economic trends will continue."

US investors have been pricing in expectations for the central bank to downshift its next rate hike to 25 basis points at the upcoming February 1 policy meeting, down from 50 basis points at its December meeting. The benchmark rate stands at 4.25%-4.5%.