Pay No Attention to the Man Behind the Curtain!

It was a roller coaster of a ride for stocks this week, punctuated by a 5.5% gain on Thursday for the S&P 500.
We are not yet back in Kansas – the largest one-day gains are typically registered in bear markets.
It will take more than clicking our heels three times to get back home. By the Fed’s own admission, the window for an economic soft landing is getting narrower. The implication is that the window for a hard landing is getting wider.
We continue to advise that it is no longer productive to focus purely on Fed action/inaction. We are close, if not at, restrictive monetary policy. The focus now should be on the economic data, especially labor statistics. Everyone is waiting for the Fed to pivot on monetary policy, but that is very unlikely to happen until the labor market finally weakens (i.e., a recession begins).

Yes, Thursday was an amazing day, and it is producing great headlines and I’m sure viewership on CNBC and Bloomberg was way up, but in the grand scheme of things, it means little. The 5.5% gain for the S&P 500 on Thursday was impressive, but it did not rank anywhere near the top 20 days in S&P history, which you can see below. What is interesting to note is that these top 20 days all occurred in bear markets. You just don’t see days like Thursday in bull markets, so don’t get too excited.

It is also important to note that the strong stock market late this week has the effect of easing policy, which is working against the desires of the Federal Reserve. Consistent with our ‘Coasting Down the Mountain’ theme, look for Fed commentary to put a damper on this weeks’ enthusiasm. The Fed needs a steady speed…not too fast, not too slow.

Yes, Inflation is Easing…

… But it’s still very high. The reason for the huge stock market rally on Thursday was a better than expected inflation report. Headline CPI was up 0.4% in October, the same as September, but over the last year, inflation declined from 8.2% to 7.7%. The more closely watched core inflation, that is, excluding food and energy, rose 0.3% in October, down from 0.6% in September. Over the last 12 months, core inflation rose 6.3% in October, vs. 6.6% in September, led by a 2.4% decline in used car prices (FYI, new cars rose 0.4%).

The change in direction was welcome news, but we still have a long way to go. The chart below takes the current inflation data and projects a steady rate of 0.1% to 0.5% per month increase over the next year. Even if core inflation stayed at a 0.3% increase in each if the next 12 months (red line), the core inflation rate in a year would still be 3.7%, well above the 2% target. We’re happy with the inflation news, but it needs to keep getting better from here.

The Red Ripple

Although we got there in an unexpected way, the results appear to be consistent with our general conclusions. Despite an inexplicably long time to count votes in several states (Maricopa County says they will not finish until next week), the result looks fairly clear. The House is likely to go to GOP control. The Senate will likely be decided in early December in another runoff election in Georgia, but if the House belongs to the GOP, even if the Democrats hold the Senate, we will have gridlock.

Historically Congressional gridlock has been good for markets. When Congress is unable to pass any massive legislation, along with the associated unintended consequences, there fewer uncertainties for the stock market. Our concern is that gridlock also makes it difficult for Congress to implement fiscal policy, which could be desirable in the event of a recession, which we believe is coming.

It is hard to tell where that leaves Donald Trump, but there is no way to view the midterms as anything other than a defeat for Mr. Trump. Now add the outlier, red wave in Florida to the mix, and we have a wide-open invitation for Florida Governor DeSantis to run in 2024. Now factor in that Mr. Trump will be 78 years old in 2024, and 82 when his term would theoretically end. Might his base begin to shift to a new standard bearer in the form of Governor DeSantis? Might the fluid situation invite others, like Tim Scott, the South Carolina Senator, to join the fray? Is there a chance Trump might step aside? The race for the GOP nomination in 2024 just got a lot more interesting.