Markets happy ahead of Fed meeting

This week is critical for the stock market. To put the case in perspective, markets have seen strong gains since the start of the new year, particularly in European and Asian markets, as inflation and economic pressures eased in Europe and as China reopened from COVID. This has helped increase risk appetite in international markets to the extent that, by many measures, risk appetite is now at its highest level in 10-15 years, suggesting that investors are becoming complacent.

This complacency is also seen in low levels of market volatility and also in the performance of meme stocks. This is a critical week because not only do we have earnings from some of the biggest companies in the world like Apple and Amazon.
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but on Wednesday night we hear from the Federal Reserve.

Reversal of inflation

If inflation eases, and it looks like it has already peaked, the Federal Reserve is expected to raise interest rates by 25 basis points, with the possibility of another hike next month. Much will depend on Fed Chairman Jerome Powell’s press conference in terms of market sentiment. My own expectation is that the Federal Reserve will effectively want to curb inflation and will be willing to hold interest rates longer. In that context, I expect Powell to strike a hawkish note Wednesday night.

Indeed, it is unlikely that he could do otherwise. It’s just unlikely that he could allow markets to rise further, which would add fuel to improving financial market conditions, which could potentially lead to higher crude prices, which in turn could fuel higher inflation year-on-year.

It’s a tough environment for the Fed. While inflation is falling, many leading economic indicators, such as the new orders component of the ISM manufacturing index and various other Fed survey indicators, point to a sharp slowdown in growth. There are large parts of the economy that look strong. The labor market is very strong, many households and companies not only in the US but also in Europe have healthy and strong balance sheets, and this has the potential to keep inflation high for the foreseeable future.

Sado-monetarism

To that end, the risk for the Federal Reserve is that inflation becomes sticky or that we get entrenched 4 to 5% inflation as a trend. The Fed won’t want that, and their task, in a sado-monetarist sense, may mean that they must break the pillars of the economy until inflation is decisively down to two, potentially to 2%.

So my expectation is that we see volatility pick up on Wednesday. Markets are vulnerable to a wave of risk aversion selling.

Also unlikely given the news from its supply chain that Apple is going to report very strong results overall over the next three months, the scenario I see is that the S&P 500 falls to the 3,600 level and maybe lower than that. until we start to see buyers stockpile assets and then prepare for a more durable decisive rally towards the end of Q1.