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Stocks Rally to 2023 Highs While Inflation Stalls Above 3%: What Will the Fed Do?

Published 13/12/2023, 10:19
Updated 02/09/2020, 07:05
  • U.S. stocks are in rally mode as we enter the final weeks of 2023.
  • With the final CPI report of the year out of the way, the market’s focus is now fixated solely on the Federal Reserve meeting.
  • Fed Chair Powell could strike a more hawkish tone than expected.
  • Looking for a helping hand in the market? Members of InvestingPro get exclusive ideas and guidance to navigate any climate. Learn More »

There was a little bit of something for both the doves and hawks in Tuesday’s U.S. CPI report, which showed that headline inflation continues to slow, but core prices remain sticky.

The consumer price index edged up 0.1% last month after being unchanged in October, the Labor Department's Bureau of Labor Statistics said.

In the 12 months through November, the annual CPI increased 3.1%, slowing from the 3.2% pace seen in October.

CPI Inflation Data

Economists polled by Investing.com had forecast the CPI would be unchanged for the month and rise 3.1% on a year-on-year basis.

As can be seen in the chart below, U.S. inflation has come down significantly since June 2022, when it peaked at a 40-year high of 9.1%, amid the Fed’s aggressive rate-hiking cycle.CPI Y/Y

Nonetheless, while the rate of inflation is declining, prices are still rising far more quickly than what the Fed would consider consistent with its 2% target range.

Excluding the volatile food and energy components, core CPI increased 0.3% in November after climbing 0.2% in the previous month.

On an annual basis, core CPI rose 4.0% after advancing at the same rate in October. Both readings were in line with estimates.

Core CPI Y/Y

In a worrying sign, the so-called ‘supercore inflation’, which tracks the cost of services minus energy and housing, rose 0.44% on the month, doubling from 0.22% in October.

The ‘supercore’ figure is closely watched by Fed officials who believe that it provides a more accurate assessment of the future direction of inflation.

All in all, these numbers suggest that the Fed would still need to see further progress on some of these underlying inflation measures before policymakers are comfortable cutting interest rates.

Taking that into consideration, the Fed’s inflation battle is far from over as sticky underlying core inflation persists, providing further evidence that the U.S. central bank was unlikely to pivot to interest rate cuts early next year.

All Eyes Turn to the Fed, Powell

With the CPI report out of the way, the market’s focus is now fixated solely on the final Federal Reserve meeting of the year scheduled for later Wednesday.

The U.S. central bank is widely expected to leave interest rates unchanged for the third consecutive meeting as Fed officials assess recent signs of economic softening.Fed Rate Estimates

After raising borrowing costs by 525 basis points to the current 5.25%-5.50% range since March 2022, many market participants are growing more confident that the Fed’s policy tightening campaign is all but over.

However, I believe there is a risk that Fed Chair Powell could strike a more hawkish tone than expected in his post-meeting news conference given that some underlying measures of inflation remained relatively elevated in November.

As such, Powell is likely to reiterate that the Fed will keep rates higher for longer as he pushes back against market expectations for a rate cut in the first half of 2024.

In addition, watch for the Fed chair to signal that he is not yet ready to definitively rule out further hikes as sticky inflation continues to meander along its slow, downward path.

It should be noted that despite Powell’s repeated ‘higher-for-longer’ rate warnings, investors have largely ignored him for the most part amid the belief the Fed is unlikely to raise rates any further and have started to price in a series of rate cuts beginning next spring.

As per the Investing.com Fed Monitor Tool, there is a roughly 45% chance of a rate cut at the Fed's March 2024 meeting, while odds for May stand at about 75%.

I think that a rate cut would likely only come in either June or September of next year as inflation takes longer to return to the Fed's 2% target than many had hoped.

As such, the central bank could keep policy rates in restrictive territory for longer than markets currently anticipate.

What To Do Now

Wall Street’s major averages closed at fresh highs for the year on Tuesday, as investors reacted to the latest inflation report while awaiting the Fed’s last policy decision of 2023.

The blue-chip Dow Jones Industrials Average closed at its highest level since January 4, 2022, and now stands less than 1% away from its all-time high.

Meanwhile, the benchmark S&P 500 ended at its best level since Jan. 14, 2022, and the tech-heavy Nasdaq Composite at its highest since March 29, 2022.

S&P 500, Dow Jones and Nasdaq Charts

While I am currently long on the Dow, S&P 500, and the Nasdaq 100 via the Dow Jones ETF (NYSE:DIA), S&P 500 ETF (NYSE:SPY), and the QQQ, I have been cautious about making new purchases due to signals the market is overbought.

Perhaps my biggest worry is the total lack of market fear as represented by the CBOE Volatility Index, or VIX. As seen in the chart below, the market fear gauge tumbled to its lowest level since January 2020 on Tuesday.VIX Chart

When the market fear gauge gets unusually low, it's a sign of excessive bullishness or complacency. That raises the risk of a market pullback.

As such, I used the InvestingPro stock screener to identify top-quality stocks with strong fundamentals and more upside ahead based on the Pro models.

Not surprisingly some of the names to make the list include Google-parent Alphabet (NASDAQ:GOOGL), Warren Buffett’s Berkshire Hathaway (NYSE:BRKa), ExxonMobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), Salesforce (NYSE:CRM), T-Mobile (NASDAQ:TMUS), Pfizer (NYSE:PFE), Qualcomm (NASDAQ:QCOM), Amgen (NASDAQ:AMGN), and ConocoPhillips (NYSE:COP) to name a few. InvestingPro Screener

Source: InvestingPro

With InvestingPro's stock screener, investors can filter through a vast universe of stocks based on specific criteria and parameters to identify cheap stocks with strong potential upside.

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Disclosure: I regularly rebalance my portfolio of individual stocks and ETFs based on ongoing risk assessment of both the macroeconomic environment and companies' financials.

The views discussed in this article are solely the opinion of the author and should not be taken as investment advice.

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