Beware the most crowded trade on Wall Street: next year’s soft landing

An outcome other than a soft landing would definitely be a problem for markets. But it is also that so much is riding on its happening. A soft landing isn’t just priced—it is priced in and more. (Photo: AFP)
An outcome other than a soft landing would definitely be a problem for markets. But it is also that so much is riding on its happening. A soft landing isn’t just priced—it is priced in and more. (Photo: AFP)

Summary

Each of the past three years had a similarly strong consensus that proved entirely wrong.

At the end of last year, investors thought recession was a done deal. The year before, they thought big tech would be immune to rate increases. And a year before that, they were convinced that paying high prices for stocks popular with the wider public would make them rich.

This December, they believe, again with absolute conviction, that the economy is heading for a soft landing and lower interest rates. Maybe this time they will be right.

Then again, maybe not. Being in the crowd is always an uncomfortable place for an investor, but agreeing with such a strong consensus is especially difficult, because if it turns out to be wrong, the punishment from the markets will be painful—just as it was in each of the past three years.

The consensus that next year the Federal Reserve will be able to slash rates without facing recession was strong even before the central bank put out a dovish forecast on Wednesday. It got even stronger as a result of the Fed’s new “dot plot" of forecasts, with futures traders now putting a 16% probability on a rate cut as soon as next month and an 82% chance of a cut by March.

The reaction to the Fed wasn’t really about what the Fed predicted, though. The median policy maker’s “dot" forecast of interest rates at the end of next year dropped to 4.6%, from 5.1%. But the federal funds futures market is 99.5% confident that rates will be much lower, according to CME Group’s FedWatch. In fact, futures traders think it is almost 50-50 that rates will end next year below the lowest forecast—3.9%—from a policy maker.

Instead, investors took the Fed’s prediction—and Chairman Jerome Powell’s answers at a press conference afterward—as evidence that they were right to think the Fed would cut rates early and often as the economy glides smoothly into that rarest of outcomes, the soft landing.

An outcome other than a soft landing would definitely be a problem for markets. But it is also that so much is riding on its happening. A soft landing isn’t just priced—it is priced in and more.

“Talk to investors and there’s this strong sense that we get through this rate cycle without any major accidents," says Peter Oppenheimer, chief global equity strategist at Goldman Sachs. “It may still be a bit naive and premature to believe that." Goldman has been arguing for a soft landing since last year, but the market’s rapid rally has already caught up with the bank’s three-week-old S&P 500 forecast for the end of next year.

What’s surprising to me is that there seems to be so little investor concern that a slow-growing economy will turn into something worse, or that inflation proves stickier than expected. Signs of interest rates hitting the real economy are being treated as outliers, while investors are willing to bet big that recent low inflation—below 2% annualized for the past two months—is here to stay, even though inflation was more than twice as high in the previous two months.

Rather than worry, investors have piled back into the interest-rate-sensitive stocks they dumped earlier this year. Speculative technology and biotech stocks have soared, while banks and real estate have done well. The Ark Innovation ETF is up 48% since the end of October, the bank sector gained 26% and real estate increased 22%.

The stock market has also broadened out beyond the handful of big-tech winners of the artificial intelligence boom, with the equal-weighted S&P 500 ahead of the ordinary market-value-weighted version since then—and both up more than 12%. The Russell 2000 index of smaller companies, which had been struggling in part because small firms have so much debt to refinance, has risen 20% from the end of October.

Investors have also switched from fear to greed in the options market. The VIX gauge of implied volatility this week reached its lowest since before the pandemic lockdowns in 2020. The ratio of put options written to protect a portfolio to bullish call options has plunged back to what counted then as unusually low levels.

Each of the past three years had a similarly strong consensus that proved entirely wrong. I don’t know whether next year will bring a rare soft landing and equally unusual correct consensus. But even if it works out, the market gains to be had from betting on something happening that pretty much everyone agrees will happen aren’t likely to be large.

Write to James Mackintosh at james.mackintosh@wsj.com

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