Looking For Light at the End of the Tunnel

Stocks opened mixed this morning (Dow +75 points; SPX -.1%). The VIX Index—measuring fear among traders—dropped back to 23. So we’re not seeing a lot of fear at the moment. But the dollar appreciated against a basket of foreign currencies, and in this environment it’s tough for stocks to rally in the face of a strong dollar. For the same reason, WTI crude oil is back down under $87/barrel. Bonds are trading lower across the board, pushing yields a bit higher.

This morning Fed Vice Chair Brainard said she believes it will “soon” be appropriate to slow the pace of interest rate hikes. One could interpret that as positive, but traders are focusing on the “not yet” aspect of that statement. They want to Fed to declare victory in the war on inflation and pledge to stop raising rates. That isn’t going to happen; this process needs to play out.

Speaking of playing out, Morgan Stanley’s Mike Wilson reiterated his 2023 outlook in a note to clients this morning. The bottom line: while he sees light at the end of the tunnel, the next few months could be very choppy. We’ve already gotten our year-end rally, and markets will struggle in the near-term as they deal with slowing economic growth and corporate profits. He’s guessing we’ll see another dip for the stock market early next year, but that will be followed by a “strong rebound” as markets sniff out the next “growth reacceleration.”

As I’ve said repeatedly, we need to see clear evidence of slowing inflation before the Federal Reserve will relax its hawkish monetary policy stance. A change in stance would be key to fostering a sustained recovery in capital markets. Analysts at Goldman Sachs think we’ll get that evidence next year. They cite three reasons why we could see the Fed’s preferred inflation gauge (“Core PCE Deflator”) fall from 5.1% to 2.9% by the end of 2023. First, global supply chains continue to heal from Covid-related disruptions. Second, rent inflation—a huge portion of the PCE index—will finally begin to ease. Third, wage growth is already beginning to slow. Of course, 2.9% core inflation is still above the Fed’s 2% long-term target, so Goldman wonders whether the Fed might feel pressure to bring inflation down further. In that case, we shouldn’t expect any reduction in interest rates next year. Many investors think that’s OK, as long as rates don’t continue rising through the year. Investors generally expect the Fed to reach its “terminal” rate level by May.