Stocks rallied 3% last week after US inflation, at 8.5%, came in lower than expected.
The inflation problem is, however, far from being solved.
Wages are increasing at 7%, the highest for decades.
The Cleveland Fed’s inflation measures indicate underlying inflation is running at 5-6%.
This is consistent with the New York Fed’s gauge of trend inflation, which is also at 5-6%.
Thus, while inflation will surely fall further from 8.5% thanks to plunging commodity prices, it may settle in the ~5% area, absent further action from the Fed.
If so, the Fed will have little choice but to increase interest rates beyond what the market currently expects. The Fed funds rate may end up at 4.25%, as opposed to ~3.5% expected by the market, and the 10-year yield may increase to 4%.
This would be very bad news for the stock market because the higher the interest rate, the lower the fair value of stocks.
Our scenarios for the $SPX500 are:
1 (Recession). Inflation proves persistent and the Fed raises rates to 4.25%. There is a recession. $SPX500 falls to 3000, 15x 2023 earnings of $200.
2 (Stagflation). Inflation proves persistent but the Fed, for political reasons, doesn’t raise rates to bring it back under control. $SPX500 falls to 3900, 16x 2023 earnings of $244, because inflation has historically depressed equity valuations.
3 (Soft landing). Trend inflation falls to 2-3% and the Fed doesn’t have to raise rates beyond what’s currently expected. $SPX500 rises to 4600, 19x 2023 earnings of $244.
We assign a significant probability to scenario 1, while the market seems to have concluded that scenario 3 is by far the most likely one.
Given our view of the probabilities of different scenarios, we continue to hold a defensive posture. This is in part a risk management measure: losing 30% if scenario 1 plays out wouldn’t be fun. Better risk-reward will be available when the economy bottoms next year, in our view.