The S&P 500® The index had risen for five consecutive weeks through Nov. 5, gaining 7.8 percent in the process. But, following the October CPI report of November 10, which showed headline inflation up 6.2% over the previous twelve months, stocks struggled to gain ground. News of the Omicron variant only added to the concern, leaving the S&P 500 down 3.4% year-to-date over the next four weeks. Over the past week, however, the tone has turned more positive, with investors being encouraged by anecdotal and even scientific evidence that symptoms related to the Omicron variant were less severe than expected, despite being more transmissible. The S&P 500 Index rebounded from a strong 3.3% to a new high, rising even after the November CPI report on Friday showed a 6.8% increase, the fastest in nearly 40 years .
Last week’s gain has left stocks virtually unchanged for the past five weeks. If we examine Omicron’s so far short-lived decline, admittedly a leap of faith at this point, we end up with the overarching question of inflation and its direction. This is the main question the Fed will face this week. It has already started to decline and Powell dropped the transient qualifier. And there is every reason to expect the pace of reduction to accelerate. The Fed is encouraged to complete the cut by March, paving the way for more flexibility to raise rates as soon as it sees fit.
The Fed is preparing if inflation persists; Investors expect rates to rise in the second half of 2022
Investors get nervous whenever monetary policy threatens to tighten. Never mind that in this case we are actually talking about a policy becoming a little less accommodating. Liquidity is always provided and will remain so until the end of the tapering. It is not the same as an increasingly strict policy. But it is a necessary prelude to a stricter policy, whenever it might happen. And the markets are looking to the future. The Fed too. Both are preparing for what will be the inflationary environment in the spring and beyond. The Fed wants to be able to catch up if inflation turns out to be stronger than previously thought.
Investors now expect rates to start rising around the middle of next year and then slowly rise thereafter, with a total of two or three rate hikes by the end of the year. They are apparently comfortable with the expected trajectory, as evidenced by the fact that while stocks have mostly stagnated for five weeks, they are at an all time high. However, investor comfort could be tested on Wednesday if the Fed signals a faster and higher rate cycle than the market is currently expecting. If so, markets could come under pressure as expectations adjust.
There is no consensus on persistent inflation; Next year’s midterm elections could cause volatility
While there are a number of high profile voices issuing inflation warnings, not everyone agrees that it will be a persistent problem. Bloomberg’s composite forecast of 75 economists, made in the second week of November, projects the headline CPI to average 2.6% in the fourth quarter of next year, similar to our own forecast as forces that are currently pushing it up will eventually dissipate. If by then the Fed has raised rates two or three times, it will probably still feel comfortable doing so, although it may have been too concerned about inflation, given the continued strength of the economy expected. This would allow them to proceed slowly with any future rate hikes, a scenario that investors would welcome.
Next year is also a year of midterm elections. Whether that fits into the Fed’s calculations remains to be seen, but it’s unlikely. Of course, he would never say it. But historically, markets become a bit more volatile as elections approach. And if the Fed raises rates as well, volatility could increase more than not. But history also suggests that stock returns are above average for the twelve months following the midterm election.
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