Investing under the belief that interest rates have stabilized could backfire, some economists warn.
Stocks, particularly interest-sensitive financial stocks, have been trending higher this summer in anticipation that Federal Reserve policymakers will leave the Fed Funds rate unchanged at 6.5% at its meeting tomorrow, ending a series of rate hikes that began last summer.
Charles Blood, director of financial markets strategy at Brown Brothers Harriman, says it could be a mistake to assume the rally will continue. Such thinking ignores the softer earnings that accompany a cooler economy as well as a real possibility of further rate hikes.
"As we have noted repeatedly in recent months, the real test for the economy will be the strength in retail sales in the next three months," Mr. Blood said in a report on Friday.
If the Fed reacts to these numbers by hiking rates again in November, it could come as a bad surprise to investors who relied too much on the good news of a cool economy, he said.
James F. O'Sullivan, an economist at J.P. Morgan, said the economy is still hot. "I don't like the expression 'soft landing,' " he said, "because I don't see a landing."
Core inflation is still a major concern at J.P. Morgan. The current rate of 2.4% "reflects the overly tight economy, which is unlikely to get any relief for at least a few more quarters as growth stays strong," Mr. O'Sullivan said.
A low household saving rate and rising consumer debt are also cause for concern, said Sung Won Sohn, chief economist at Wells Fargo & Co. "Consumers can only run the kind of debt they have in part because of the wealth in the stock market," he said.
"The bottom line is, we are spending beyond our means," Mr. Sohn said. As financial wealth is soaring, he said, an ever-rising appreciation of share prices is required to keep consumer spending up and the economy away from recession.
Though a slowed economy is generally seen as good news because an otherwise inevitable rise in interest rates would send share prices down, cooling conditions could also result in a decrease of earnings from loans and fees, because of curtailed consumer spending and a restrain in the use of financial services. The squeeze of bank's profit margins is equally bad for stock prices.
But Frank Barkocy, an equity analyst at Keefe Managers, is confident that bank stocks will continue to perform well. Investors have just started to show more interest in financials, which still provide "considerable opportunities," he said.
"There is a tradeoff" between stable rates and softer earnings, "but I think the picture looks fairly benign," said Nancy Bush, a banking analyst at Prudential Securities. She said that the slowdown indicated by recent data poses no danger to earnings. And Mr. Barkocy agreed that banks are well positioned to absorb the current moderate economic growth.