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Sticky inflation could dim rate-cut hopes

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Rising bar for earnings growth makes it harder to beat

forecasts

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High valuations could increase volatility on Wall Street

By Lewis Krauskopf

NEW YORK, Sept 25 (Reuters) - U.S. stocks have hit a

string of record highs with minimal turbulence over the past few

months, but investors say the rally could be undermined by

persistently high inflation, possible earnings disappointments

and elevated valuations.

The S&P 500 has posted 25 record closing highs over the

past three months and the benchmark index is approaching a third

anniversary of a bull market that began on October 12, 2022.

Stocks shook off fears that President Donald Trump's tariffs

would cause a recession. Wall Street got boosts from trade

deals, solid corporate results and optimism over artificial

intelligence. Now, investors also are confident the Federal

Reserve will ease interest rates significantly.

The S&P 500 has risen about 13% in 2025, on track for its third

straight year of double-digit gains. It is up 33% since its low

for the year in April. The index is on track for its best

third-quarter performance since 2020.

Over the past five months, the index has yet to pull back as

much as 3%, its longest streak without such a drop since 2018,

according to Mark Hackett, chief market strategist at

Nationwide.

"I do get a little bit more nervous just about the straight

upward momentum in the market," said Anthony Saglimbene, chief

market strategist at Ameriprise Financial. "The market is

trading at levels that any kind of unexpected hiccup could cause

a near-term dislocation."

Here are some risks investors say could dent stocks:

INFLATION STAYS HIGH, UNDERMINES RATE-CUT HOPES

The Fed cut rates this month, aiming to steady a weakening

employment picture. Fed fund futures are pricing in at least

another full percentage point of easing, or four standard cuts,

through next year. Fed Chair Jerome Powell has said near-term

risks to inflation are to the upside, making for a "challenging

situation" for the central bank.

"You have a pretty strong belief in a lot of Fed cuts moving

forward ... while inflation is not necessarily under control,"

said Patrick Ryan, chief investment officer at Madison

Investments.

Inflation is still running above the Fed's 2% target. Meanwhile,

"we still haven't seen the full impact of tariffs yet on end

consumer prices," noted Allen Bond, portfolio manager at Jensen

Investment Management.

Should tariffs stoke inflation further, "then the dovish Fed

support maybe goes away," Bond added.

The monthly personal consumption expenditures price index, a

key inflation gauge, is due on Friday.

ECONOMY IS WEAKER THAN FEARED

Weak labor market reports prompted the Fed's rate cut, yet

few investors appear to be worried that the jobs situation

indicates a significant economic downturn. Any data that causes

a rethink of that could roil the market.

Historically, the S&P 500, on average, has gained 11% in

the year after the Fed started or resumed rate cuts, according

to BMO Capital Markets. In instances of recession, equities

posted sharp one-year declines despite the easing.

Investors are watching whether labor-market weakness slows

consumer spending, which accounts for over two-thirds of

economic activity. A top market risk is "a deterioration in the

U.S. consumer," said Adam Farstrup, head of multi-asset,

Americas at Schroders, adding "we haven't seen it yet."

EXPECTATIONS FOR CORPORATE EARNINGS FALL SHORT

Rising expectations for corporate earnings could make it harder

for companies to beat forecasts. Third-quarter reports kick off

in the next few weeks, and S&P 500 companies overall are

expected to increase earnings by 8.6% from the year-ago period,

up from an expected 8% rise as of July 1, according to LSEG

IBES.

"The bar has been raised a bit higher this time around, and

so I'm a little concerned that if companies fail to meet more

buoyant expectations, you could see a little bit of an

adjustment in prices," said Michael Arone, chief investment

strategist for State Street Investment Management.

Fallout from tariffs could weigh on results, investors said.

"If you see more companies saying demand is coming down or

margins might come down because of trade or tariffs... that

could be a little bit of a negative for the stock market,"

Saglimbene said.

HIGH VALUATIONS MAKE STOCKS VULNERABLE

The S&P 500 is trading at nearly 23 times forward earnings

estimates of constituents, around its highest in five years and

well above its 10-year average of 18.7, according to LSEG

Datastream.

"The valuations are very demanding," said David Bianco,

Americas chief investment officer at DWS. "I do think there will

be volatility along the way."

High valuations in megacap technology and growth stocks that

are heavyweights in indexes present a particular risk, including

if doubts emerge about the AI investment and spending.

"We haven't seen any evidence of cracks at all, but

obviously that's something that if it were to occur, I would

suspect the market would react negatively to that," Bond said.

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