Here's why investors are far too optimistic that the Fed is going to cut interest rates soon

• The S&P 500 is too expensive for an economy likely headed for a downturn, said UBS Global Wealth Management.
• "The latest labor market data looks too hot to justify a further dovish shift in Fed policy."
• Investors are expecting rate cuts to start as early as July.

Pricey US stocks suggest investors expect the Federal Reserve to start cutting interest rates soon and steer the world's largest economy away from a damaging downturn — but that view is too optimistic, according to UBS Global Wealth Management.

After the Federal Reserve's 10th consecutive rate increase last week, comments from Chairman Jerome Powell and the central bank dropping language from its statement that "some additional policy firming may be appropriate," gave the "clearest indications yet" that the Fed is drawing nearer to the end of its aggressive hiking cycle, UBS said Monday.

"But despite this positive indication, we believe equity markets have moved too far in pricing a more dovish rate trajectory, including the pace of cuts," Mark Haefele, chief investment officer at UBS Global Wealth Management, wrote in a note.

Investors anticipate the Fed's massive rate hikes over the past year will lead to a recession and foresee a nearly 5o% probability of a quarter-point decrease by September from the current 5%-5.25% range.

Meanwhile, nonfarm payroll growth of 253,000 in last week's jobs report was well above expectations of 180,000 and "too hot to justify a further dovish shift in Fed policy," Haefele said.

And while inflation is moderating, it's still too high, he added. The widely watched Consumer Price Index in March cooled to 5% but was still above the Fed's 2% target. On Wednesday, the April CPI report is expected to hold steady at 5%.

Despite all this, "valuations in the equity market are pricing in too rosy an outcome for the economy," the investment strategist said.

The S&P 500 has been trading at 18.8 times forward earnings over the coming 12 months, a 16% premium to the 10-year average.

But history shows that when the S&P 500 has traded above 18 times forward earnings, the 10-year Treasury yield is less than 2% or consensus earnings growth expectations are at 14% on average, Haefele said.

"At present, we expect S&P 500 earnings to contract 5% in 2023," he said, and the 10-year Treasury yield was up at 3.5% on Monday.

"As a result, we believe US equities are pricing a high probability of a near-perfect outcome for the US economy. Yet tighter financial conditions, declining corporate earnings, and relatively high valuations all present risks."