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Is 3% the new 2%?

September kept up its reputation of worst performing month for stock markets (October gets the bad press due to major crashes but its not even in top 3 worst performing months). Why Sept? It could be a good topic for Behavior Economics PhD - I am sure someone must have done some thesis on this. S&P fell by 4.9% while Nasdaq fell by 5.9%. While markets are still meaningfully up for the year thanks to performance of Magnificent Seven (new combo post FANG), what's in store for last quarter of 2023?

That would mostly depends on two factors - direction of inflation and interest rates. And continuation of AI momentum - sizzle or fizzle? For today,  let's focus on first factor.

Fed Chairman Powell's in-famous comment about "Inflation is transitory" caused major credibility loss for Federal Reserve. Since then Fed is doing everything to make sure that markets get the message that they are serious on bringing down inflation. Based on latest readings they are reasonably successful with inflation coming down from 9% in summer of 2022 to mid-3% - that's steep downward shift in inflation in less than 15 months. One would think Fed would be celebrating with "Mission Accomplished"....but Fed knows that it's going to take longtime and effort to gain back trust and credibility of markets. Hence Fed is extra hawkish sending its message that we are not done yet in our fight against inflation and have not budged from their stated target of bringing down inflation to 2%. There lies the problem...

There are structural changes happening to US economy (and to some extent world economy). Here are some of those.
  • Population is aging across western developed countries and even in China
  • Labor participation has reached its peak 23 years back and continues to slide down. People who left or lost jobs during pandemic are not coming back fully
  • Last cohort of baby boomers are retiring with significant amount of wealth which they are willing and ready to spend - that's why travel is booming
  • Immigration is slow or non-existent in some parts of world
  • Governments do not care about deficits no matter which party is in White House
  • AI and technology boom is creating supply-demand mismatch for qualified labor
  • Even for jobs like plumbing, carpenters, electricians, mechanics and so on, there is  shortage of skilled labor
  • Housing supply (new and existing homes) is severely constrained
So unless there is severe recession (which no one is predicting), inflation would be stubbornly high above Fed's target of 2%. Most likely it would hover around 3% for a long time despite more rate hikes. So at some point policymakers at Fed need to accept the fact that "3% is the new 2%" and adjust their policies to reflect this reality to avoid turning soft-landing into hard recession. Fed should do one more hike of 25 basis points in Nov and take pause for long time (12 months or more). The various strikes - writers strike, auto-workers strike and now possibility of projected government shutdown would reflect in employment report due next Friday. That should provide cautionary indication to Fed.

When it comes to markets - it would get adjusted to this reality post Nov and start marching upwards closing the year between 4500-4650. Q3 is closed and in 2 weeks earnings season would start. As seen in last two earnings season, one earnings report (Nvidia) would be the most influential report on entire technology industry and maybe whole market.

In meantime, enjoy the cool and breezy Fall season...I will be off to New England to enjoy the colorful Fall Foliage

/Shyam

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