Despite numerous pessimistic predictions, stocks have displayed remarkable resilience this year, steadily progressing forward. Even with a recent 2% dip, the S&P 500 has managed to surge over 17% in the course of 2023. This upward momentum has persevered through challenges such as escalating interest rates, declining earnings, the protracted Ukrainian conflict, and China’s economic woes – all of which have failed to disrupt the ongoing rally.
So, what could potentially bring this momentum to a halt?
Several strategists and economists continue to cast a wary eye on the Federal Reserve, even as it nears the conclusion of its rate-hiking cycle. Their concern stems from the widely discussed concept of “long and variable lags” associated with rate hikes. Essentially, the impact of these rate increases takes a considerable amount of time to permeate the economy and does so unevenly.
Mohamed El-Erian, the Allianz advisor and president of Queens’ College, Cambridge University, recently shared his apprehension in an interview with Yahoo Finance. Despite acknowledging the robustness of the U.S. economy, he raised the possibility of a significant policy misstep by the Fed.
“I am particularly concerned that the Fed might tighten monetary policy too aggressively, clinging to an outdated inflation target of 2%. This target may not be suitable given the current structural and supply side dynamics,” El-Erian cautioned.
El-Erian pointed out a critical flaw in the Fed’s approach – its reliance on backward-looking data for decision-making.
“My primary concern is that headline inflation could surge again by the year-end. If the Fed remains excessively data-dependent at that point, it might find itself in a challenging situation. We should encourage the Fed to adopt a more long-term view, focusing on medium-term inflation targets, and avoid jeopardizing economic growth due to short-term data fluctuations.”
El-Erian’s unease about the Fed’s direction is not unique, yet both the markets and the economy have consistently confounded expectations throughout the year. Even though, in theory, the Fed has the potential to curtail growth, the remarkable surge from zero to 5.5% in slightly over a year has not hindered the trajectory.
Jack Manley, the global market strategist at JPMorgan Asset Management, offered insights into historical trends. “If we analyze recessions spanning the last six to seven decades, a common thread emerges – an overly zealous Fed,” Manley stated. “While I won’t assert that this time is an exception, I am also not convinced that it’s a foregone conclusion, at least not in the initial half of the upcoming year.”
Investors might not be currently fixated on Fed concerns, potentially because their attention is shifting toward anticipation of future rate cuts.
In the June summary of economic projections, known as the dot plot, Federal Reserve governors projected lower rates by the close of 2024. Market participants are aligning with this perspective, with a majority of futures bets indicating a range of 3.75% to 4.25% by December of the following year.
