U.S. stocks could rally another 25% now that Fed no longer has ‘back against the Wall’ in inflation fight

See: U.S. inflation has come off the boil, but it’s going to take a lot longer to cool down

These reasons included a “meaningful slowing” in CPI month-over-month, “‘bullwhip’ payback” in durable-goods inflation and the contraction in the cost of health insurance.

• “Shelter finally showed a meaningful slowing in CPI MoM, as OER (owners equivalent rent, >23% of CPI basket) slowed to +0.6% (+0.7%/+0.8% Aug/Sept) and trending towards market reality of deflation in housing.”

• “Durable goods finally showing “bullwhip” payback as durables CPI fell to -0.7% MoM (-8.4% annualized) and even used cars finally showed some weakness down-2.4% for the month (but still 15% further to fall).”

• “Medical health insurance massively flipped to -4% MoM from 12 consecutive months of +2.4% (since Oct 2021) and given annual adjustment is set to fall 40% over the next 12M.”

All these are signs that inflation is set to “massively slow” during the coming months. If all goes well, the U.S. economy could see “three to four months” of core CPI growing at a rate of 0.3% month-over-month.

The pace of so-called core rate of inflation, which omits food and energy costs, slowed to 0.3% in October, lower than forecasts for a 0.5% increase expected by Wall Street.

The most important result of October’s inflation data is that the Fed no longer has its “back to the wall,” which could allow a more substantial easing of the pace of interest-rate hikes, Lee said. Ultimately, “the case for a pause after December is stronger.”

Market analysts have been on the lookout for signs that the Fed could either pause its aggressive interest rate hikes, or perhaps even “pivot” back toward cutting interest-rates, because it’s widely believed on Wall Street that this would help to put an end to the bear markets in both stocks and bonds this year.

The Fed has raised the Fed funds rate, a key Wall Street benchmark rate, by 3.75 percentage points since the start of the year, including four consecutive “jumbo” hikes of 75 basis points, including one earlier this month.

Even if the Fed does keep the Fed funds rate above 5% for a spell, the shift from “higher in a hurry” to “predictable but possibly longer” would be more amenable to equity valuations, Lee said.

Fed funds rate traders expect the Fed funds rate will peak at 5% in March and remain there until at least the fourth quarter, according to the CME’s FedWatch tool.

Softening inflation could also help stocks by averting a deep recession and raising the chances that the Fed can guide the U.S. economy toward a “soft landing,” Lee said.

Lee and his team said this latest rally could last for as long as 50 days and help the S&P 500 rally as much as 25% higher as investors embrace the notion that the worst of the Fed’s rate hikes are over and the central bank will likely “pause” early next year.

Ultimately, the S&P 500 should be able to surpass its 200-day moving average around 4,100. If investors receive another soft CPI report in December, the large-cap index might even reach the 4,400-4,500 range.

Sometimes described as a “permabull,” Lee stood by his bullish outlook for stocks during most of the first-half of 2022, even admitting in March that he had been “too bullish” as he continued to press his case for why equity valuations looked attractive.

U.S. equity indexes saw their best session in more than two years on Thursday as the S&P 500
SPX,
+0.10%
rallied more than 5.5%, the Nasdaq
COMP,
+27.57%
climbed nearly 7.4% and the Dow Jones Industrial Average
DJIA,
-0.32%
advanced more than 1,200 points. Stocks look set to open higher and add to these gains on Friday.