Why a jump in economic growth could be the stock market’s nightmare scenario

An acceleration of economic growth in the US might be the stock market’s worst-case scenario, according to GlobalData TS Lombard chief economist Steven Blitz.

While that may sound counterintuitive, as a recession would also not be great for stocks, Blitz wrote in a note on Tuesday that the “no landing” scenario is a big risk as it could lead to a fresh spike in inflation and an about-face by the Federal Reserve.

“What has now become the biggest risk in the Fed’s cut and aggressive guidance, and the one markets are not pricing – that there is no landing at all,” Blitz said.

Blitz is concerned that the Fed will keep interest rates too low for too long, leading to a hot economy and making inflation once again Wall Street’s biggest worry.

“The Fed will not get the funds rate down to 3%, but the terminal rate for this round will nevertheless end up too low and be kept there for too long. Inflation subsequently rebounds and the Fed is back raising rates sooner than anyone expects,” Blitz said.

That would be a wake-up call for investors, especially as the “Goldilocks” dream of a soft landing in the economy becomes the consensus on Wall Street.

According to Blitz, the Fed funds rate should settle at around 4%, a full percentage point above the long-term projections of numerous Fed members, because the economy is still showing remarkable resilience.

“One cannot ignore that in the face of higher real rates versus pre-Covid, the economy has stayed strong and employment full,” Blitz said.

The Atlanta Fed’s GDPNow estimate for third-quarter GDP growth is 2.9%, imports on a year-over-year basis are seeing an uptick, and more containers are “riding the rails” in a positive sign for economic health, Blitz observed.

None of those signals suggests that the Fed needs to follow through with aggressive interest rate cuts like the futures market is currently projecting, he said.

The CME’s FedWatch Tool is pricing 75 basis points of interest rate cuts before year-end, in addition to the Fed’s 50 basis point rate cut last week.

“Running a too-low real funds rate, which this Fed is apt to do, consequently risks a much higher inflation outcome than they are assuming,” Blitz warned.

The potential Fed policy mistake that Blitz is so worried about would mirror the 1960s, according to the note, which helped fuel a painful decade ahead of high inflation and poor stock market returns.