Investor confidence drove stock valuations higher in recent weeks, though strong wage growth pressuring inflation and emerging cracks in an otherwise strong US economy threaten to upend expectations.

A rally in the S&P 500 this year has pushed stock prices more than 20 times higher than projected earnings for the next 12 months. Generally, a rise in this key valuation metric, the forward price-to-earnings ratio, indicates investors largely expect future earnings to grow.

Expectations that the Federal Reserve is done with one of the most aggressive rate-hiking cycles in its history and that the central bank will begin to cut rates have boosted valuations. While inflation has fallen from its 2022 peak, the Fed's preferred measure of rising prices remains significantly higher than the target level, raising the possibility of further rate increases to come. Combined with signs of slowing economic activity, it suggests investors' confidence in the market may prove misplaced.

"There's a sense that we're near the peak in the Fed's policy rate," said Joel Prakken, chief US economist at S&P Global Market Intelligence. "I think there is a risk there … a change in these expectations would definitely take some wind out of the stock market."

Earnings

The second-quarter earnings season has been mixed, with most companies beating estimates but recording weaker revenues, said Matthew Weller, global head of research at StoneX, in an Aug. 7 research note.

"Traders are punishing a couple of the most highly-weighted 'Big Tech' behemoths like Apple and Tesla, which is dragging down concentrated market cap-weighted indices like the S&P 500," Weller said.

Two of the S&P 500's heavyweight stocks presented a mixed view Aug. 3, with Apple Inc. forecasting revenues will fall in the September quarter, while Tesla Inc. disappointed investors by suggesting production numbers would drop while prices could be cut further to stimulate demand.

Yet equity prices have been steady since earnings season kicked off in mid-July with the S&P 500 up 0.19% since July 13.

"The rally we've seen has been strong for several months now, and data is now starting to back it up. It's typical to see prices lead recoveries, so I'm not as concerned with higher [price-to-earnings ratios] or excessive optimism just yet," said Callie Cox, a US investment analyst at eToro.

Wage growth pressures inflation

The Fed in July boosted the benchmark federal funds rate by 25 basis points to a range of 5.25% to 5.5%. Most futures market investors view this as the final increase before officials begin cutting rates in 2024, according to the CME FedWatch Tool.

Fed Chairman Jerome Powell said after announcing the July rate decision that while officials would consider further rate rises, the full effects of its actions since March 2022 have yet to be felt.

In another sign that investors believe the worst of monetary policy tightening has passed, the CBOE Volatility Index in July fell to its lowest level since before the COVID-19 pandemic. The index, which is also known as the stock market's "fear gauge," is one measure of the cost to protect against stock market losses with options.

"Markets and the Fed are taking the same view — the peak in rates is near, if not already here," said Cox with eToro.

Yet tightness in the labor market persists, stunting the decline in wage growth that the Fed hoped would be a result of its rate hikes.

At around 5%, the average hourly earnings of all employees is now outpacing inflation, potentially sparking a wage-price spiral that moves businesses to keep raising prices to protect margins.

"I think the market is overlooking the probability that inflation is not done, not over, and not finished," said Steve Deppe, chief investment officer at Nerad + Deppe Wealth Management.

Warning signals mar bright economy

The improving outlook for the US economy is also driving investor confidence. Real GDP grew 2.4% annually in the second quarter, an acceleration from 2% in the first quarter, the Bureau of Economic Analysis reported July 27. The increase in real GDP, one measure of the inflation-adjusted size of the US economy, was largely driven by consumer spending and business investment.

However, continued acceleration in the economy threatens to push inflation higher if demand for goods and services continues to grow, said Sonu Varghese, a global macro strategist with Carson Group.

"In which case, the Fed may have to keep rates longer than what markets currently expect, or worse, even hike further," Varghese said.

Avoiding a recession in the US is not guaranteed. Growth is slowing in other parts of the world, with much of Europe flirting with recession and China's economic progress stunted by disappointing consumer spending.

There are also weakening signals in the US. The ISM manufacturing index came in at 46.4 in July, marking the ninth consecutive month of contraction, drawing comparisons to the downturn in the mid-90s. Meanwhile, excess savings have been run down while the lagged effects of high interest rates could still come to bite. Economists at Wells Fargo suggest a recession remains likely.

If growth continues at its current pace, though, that will likely push the Fed into further monetary policy tightening, said Prakken with Market Intelligence. Unemployment will fail to rise to a level sufficient to cool wage growth, further preventing inflation from falling closer to the Fed's 2% growth target.

"We're going to have to see a higher peak in the funds rate than is currently priced into markets," Prakken said.