Why it might be time to strap in for a wild end to 2023 on markets

Locally, the apparent change of sentiment that has underpinned the rally over the past six weeks has taken place against the backdrop of a market where almost 50 companies have short positions of 4 per cent. They are led by lithium miner Pilbara Minerals, where a stunning 20.8 per cent of shares are held short.

The broad level of shorting is likely to have exacerbated the strength of the recent rally. As shares have kept rising, a greater number of short sellers will have been forced to cover their positions by buying stock. There are still 44 companies with short positions greater than 4 per cent, so short covering could well continue in the lead up to the New Year.

The big question

But the big question, of course, is whether this rally can continue – and much will depend on the news and sentiment out of the US.

Hopes that the Federal Reserve will be cutting interest rates as early as March next year reached fever pitch last week after the Fed released projections from officials suggesting at least three cuts. Chairman Jerome Powell didn’t push back on the market’s dovishness either. Wall Street’s S&P 500 finished the week up 2.7 per cent, and has now risen almost 15 per cent since the end of October.

The size of the rally is impressive, but it is the speed that is most startling. We’ve spent much of this year talking about the Magnificent Seven tech stocks that have led the market higher – the combined market capitalisation of Apple, Tesla, Microsoft, Nvidia, Alphabet, Meta Platforms, and Amazon is on track to end the year at almost $US12 trillion ($17.9 trillion), up $US5 trillion in a year. But the recent rally has broadened out significantly.

Wall Street’s small cap index, the Russell 2000, has surged 21 per cent since the end of October. Even more incredibly, it went from a 52-week low to a 52-week high in just 48 days, the fastest turnaround in more than 50 years.

Where to now?

The ‘no landing’ scenario

Not surprisingly, the Fed is trying to take back the petrol it poured on the rally last week. New York Fed president John Williams declared on Friday night that the central bank was not really talking about rate cuts yet. Chicago Fed president Austan Goolsbee followed this up with a warning about inflation on Sunday. “We’ve made a lot of progress in 2023, but I still caution everyone, it’s not done,” he said.

The market will probably ignore these Fed speakers given Powell’s dovishness last week. But the comments do remind us that the soft landing scenario that is well and truly priced into markets faces two potential challenges.

The first is a hard landing, whereby the economy rolls over much faster than either investors or central banks think. That would mean rates will need to fall even faster than expected. But it would also probably mean corporate earrings would be hit hard and share prices would retreat.

However, the second, and probably more intriguing, challenge is the “no landing” scenario. Here, the economy remains more robust than expected, interest rate cuts don’t come, and inflationary pressures threaten rate rises again.

There are plenty of signs of weakness to say that won’t happen, particularly in global manufacturing sectors, where there is weakness in jobs and new orders, and the US small business sector, where capital appears to be drying up.

But while labour markets remain as tight as they are, economies may remain resilient. As Bank of America’s Michael Hartnet points out, there have been only five times in the past 90 years when the Fed has cut rates while US unemployment (now 3.7 per cent) has been lower than core inflation (currently 4 per cent).

His view is that the soft landing sentiment can keep markets rallying until investors get spooked by evidence a hard landing is coming, or evidence that the Fed has failed to kill inflation and must do more.

For now, the bulls are in charge. But after such a big run, don’t be surprised if things get interesting in the next couple of months.