Markets Are Complacent Ahead Of The Fed Meeting

This week is a critical one for the stock market. To set the scene markets have rallied strongly since the start of the new year in particular European and Asian markets as inflation and economic pressure have eased in Europe and as China reopens from COVID. This has helped to boost risk appetite across international markets to the extent that on many measures risk appetite is now hitting its high level its highs of the past 10 to 15 years suggesting that investors are becoming complacent.

This complacency is also evident elsewhere in the low level of market volatility and also in the performance of ‘meme’ stocks. It’s a critical week because not only do we have earnings from some of the biggest companies in the world such as Apple and Amazon
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but on Wednesday night we hear from the Federal Reserve.

Inflation turning

With inflation coming down and looking like it has already peaked the Federal Reserve is expected to increase interest rates by 25 basis points with the potential for another increase in the following month. In terms of market sentiment a lot will depend on the press conference from the Fed chair Jerome Powell. My own expectation is that the Federal Reserve will effectively want to kill off inflation and will sound prepared to keep rates higher for longer. In that context I expect Powell to strike a hawkish note on Wednesday night.

Indeed it’s unlikely that he can do the opposite. It’s simply unlikely that he could allow markets to rally more which would add further fuel to improving financial market conditions potentially to commodity prices and then this in turn could spur inflation higher later in the year.

It’s a difficult environment for the Fed. While inflation is coming down and many lead economic indicators such as the new orders component of the ISM manufacturing index and various other readings from Fed surveys point to a sharp slowdown in growth. There are large parts of the economy that appear robust. The labor market is very strong many households and companies not just in the US but also in Europe have healthy and strong balance sheets and this has got the capacity to keep inflation at a high level for the foreseeable future.

Sado-monetarism

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

So my expectation is that on Wednesday we see volatility push higher. Markets are vulnerable to a sell off to a wave of risk aversion.

It’s also unlikely, given news from its supply chain, that Apple is going to report very very strong results overall over the next three months the scenario I’m looking at is that the S&P 500 index trades down towards the 3600 level and perhaps below that until we begin to see buyers accumulate holdings and then prepare for a more durable decisive rally towards the end of Q1.

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