"Don't fight the Fed" is an oft-quoted market saying that has remained sage advice for the past decade or two. Recently, however, it appears investors are thumbing their noses at that advice.

 

This week, Fed Chairman Jerome Powell and his FOMC members released yet another warning that they see a long drawn-out battle with inflation that will last well into next year. Given the decline in bond yields and the rise in equity indexes, the financial markets appear to disagree. Who will turn out to be right has major implications for what happens to financial markets into the New Year.

 

The recent good news on the inflation front — lower monthly Personal Consumption Expenditures Price Index (PCE) and the Consumer Price Index (CPI) data — has convinced investors that inflation is on the run. The expectation that core inflation could fall as low as 2.6 percent by the end of 2023 is the bull case. They argue that global supply chain disruptions were the main cause of the inflation spike. That problem is disappearing quickly and as it does, so will inflation.

 

If so, inflation could fall to the Fed's target rate of 2 percent within the next 12 months. Some investors believe that the Fed will not only need to back off from raising rates but likely begin to cut interest rates to avert a serious recession. As such, the bulls have been bidding up stocks and buying bonds.

 

The Fed is on the opposite end of the spectrum. Chair Powell has remarked on several occasions that headline inflation, as represented by the Producer Price Index and the Consumer Price Index, is not a good indication of the true rate of inflation. Why?

 

It is because energy, durable goods, and shelter are three areas heavily represented in those indexes and are strongly influenced by supply chain disruptions. The Fed is looking more at variables like service prices, which are labor-intensive, and have more to do with aggregate supply and demand. That puts employment squarely in the central bank's cross hairs and they see little in the way of a slowing down in job growth.

 

Despite two monthly declines in the rate of inflation as represented by the CPI, the Fed has raised its forecast for inflation next year to 3.1 percent, and its core inflation (ex-food and energy) forecast to 3.5 percent from 3.1 percent.

 

The Fed also sees meager growth in GDP (plus-0.5 percent), while many economists had been predicting at least a moderate recession beginning in either the first or second quarter of 2023. Now, it appears that there is a growing consensus among a group of bulls who think a mild recession at most will reduce the inflation rate quickly as supply chains continue to recover and expand.

 

There are a couple of flies in that ointment, from my perspective. Even if inflation was solely the result of supply chain disruptions, why are the bulls so sure that supply chain problems will disappear, never to return?

 

China, the main cause of those disruptions, is giving up its zero COVID-19 policies, but as a result, the infection rate among the Chinese population is skyrocketing with a real possibility that supply chains may come under pressure once again. Our own country is not immune to another resurgence of COVID and possible supply chain issues.

 

Omicron BQ, and XBB, are COVID subvariants that are currently causing 72 percent of new infections in the U.S. They are the most immune evasive variants of COVID-19 thus far. Present vaccines and boosters are "barely susceptible" to neutralizing the disease, according to the U.S. Centers for Disease Control. The holiday season might usher in a big spike in infections with all the lost productivity that could entail.  

 

In my opinion, it seems far too early to claim victory on the inflation, interest rate, and growth front. The disappointing FOMC meeting this week may convince investors that stocks are ahead of themselves. We have not been able to break the top end of my target range (4,000-4,100) thus far on the S&P 500 Index. "Don't fight the Fed" seems good advice to me.

 

I am sticking with my cautious forecast and believe that the markets need to pull back to test the 3,700-3,800 level on the S&P 500.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.