Stocks may rally if global central banks ease up on rate hikes, but inflation could rebound and spark more volatility, Charles Schwab says

• There are good, bad, and ugly outcomes for the stock market as inflation continues to weigh, Charles Schwab warned.
• Though inflation is coming down, it could easily rebound if central banks begin cutting too soon.

Stocks could spin three ways as inflation begins to cool, Charles Schwab analysts said in a note on Monday, outlining a good, a bad, and an ugly outcome for the market.

The good: stocks could rally as central banks ease up on rate hikes. The bad: inflation could rebound and set off even more volatility. The ugly: central banks will stay hawkish and send stocks lower.

The Fed just issued its third 75-point rate hike this year, and the European Central Bank has also hiked by an unprecedented 75 points, causing stocks to recoil in volatility.

A good outcome

If inflation continues its slow descent, markets could rebound on hopes that aggressive rate hikes will end, Schwab said. US inflation cooled slightly to 8.3% in August from 9.1% in July, sparking talk that inflation may have peaked.

Some central banks have already indicated they may be nearly done with hiking rates: Brazil's central bank stopped hiking in August, and Norway's central bank suggested its most recent 50-point rate hike could be its last, or close to it, analysts said.

"Should inflation begin to recede significantly around year-end due to a softer labor market and easing housing inflation ... markets may rebound on prospects for an end to the aggressive rate hikes of 2022," analysts said. They noted though that economic growth could be slowed, as demand will take a time to pick up again, and central bankers are likely to remain cautious for any rebound of inflation.

A bad outcome

But inflation could come back, if central banks ease too soon, Schwab warned. The global policy rate for developed markets excluding the US is still low historically and remains "deeply negative" — even lower than the rate that preceded the Great Recession in 2008, analysts said.

"If central banks respond to a weakening labor market and stop hiking too soon or cut rates while the real policy rate is still firmly negative, there's a chance inflation may rebound. If it does, even higher rates may be needed to quell inflation," the note said.

That would be a repeat of the 70s and 80s when central bankers pivoted monetary policy too quickly, leading to a "whipsaw" effect in stocks.

"This whipsawing pattern may support a continued environment of volatility and wide market swings as seen this year," the bank warned.

The ugly outcome

And then, there's the possibility that central banks will actually do what they say and stay hawkish until inflation is dead. In that scenario, expect another year like 2022, Schwab said.

"Stocks would have further to fall with both price-to-earnings (PE) ratios and earnings contributing to declines; any prospect of a deep recession would likely force analysts to cut earnings estimates," analysts warned.