Stock Market Predictions 2023: Why the Fed Still Doesn’t Care About Wall Street


Stock market predictions - Stock Market Predictions 2023: Why the Fed Still Doesn’t Care About Wall Street

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Who do you favor, Wall Street or Main Street? This dynamic in financial markets, as well as in monetary and fiscal policy decisions, has existed for decades. The belief is that Wall Street profits from movements in financial markets while Main Street benefits from underlying trends in the real economy. Decisions made by the Federal Reserve and U.S. government will then tend to favor one group over the other. This battle between the two “Streets” has been central to determining stock price and economic direction for a long time.

There is very little doubt that monetary policy over the last 20-plus years has favored Wall Street with growth in financial assets and corporate profits largely outpacing growth in the real economy and worker wages. The wealth and income gap in the United States is extraordinary. Strong productivity, driven by technological innovation, kept inflation largely at bay and allowed the Federal Reserve to continue to pump money into the economy whenever growth faltered.

However, with inflationary dynamics present in the current economy, this power struggle between Wall Street and Main Street is changing fast. The Federal Reserve is now sacrificing its support for Wall Street to ensure a sustainable Main Street recovery. And this is a major problem for stocks in 2023.

Without incremental liquidity, the bearish trend is likely to remain in place.

Federal Reserve Liquidity Drives Stock Prices

My investment framework focuses on the notion that understanding whether the Fed is adding or subtracting liquidity is the most important driver of whether we are in a bull or bear market.

After more than a decade of constant Fed intervention to keep interest rates low, I believe that financial markets are in constant need of something I have coined as the “perpetually accelerating liquidity machine (PALM)” that comes from the Federal Reserve.

In a low population growth, low productivity world that is highly financially levered, the U.S. economy needs constant Fed liquidity in the form of low rates — and often asset purchases — to achieve higher rates of growth and profits. Without this central bank assistance, the economy and financial assets struggle. Thus, figuring out the timeline toward incremental Fed liquidity additions has become perhaps the most important determinant of whether stocks as an asset class are going up or down.

If this timeline to Fed liquidity is expanding because the Fed is too far from its mandate to provide stimulus (like now), this is generally bad for stocks. When this timeline to Fed liquidity narrows, then stock markets tend to rally.

Are We Getting Fed Liquidity Now? No, We Are Not.

Considering this framework, the question to answer as we start 2023 is what conditions are necessary to get the Fed’s “PALM” to resume. For this to happen, I believe three conditions need to be met in order.

First off, we need to see economic growth momentum in the U.S. begin to roll over. Secondly, this rollover in economic growth needs to lead to a substantial fall in headline inflation. Lastly, this slowdown in growth and fall in inflation need to lead to a slowdown in the labor market and a rise in unemployment, which would lower wage growth momentum enough to stomp out the core services inflation that has become the Fed’s largest worry.

Regarding the first step in this process, we have begun to see some signs that growth momentum is decelerating as evidenced by Manufacturing and Service ISM contracting in the month of December. I suspect these ISM surveys will continue to roll over nicely in the coming months, as the lagging impacts of higher interest rates are finally catching up to the economy.

On the inflation side, while it is likely we have seen the peak in headline inflation, the biggest issue for the Fed, and thus for the stock market liquidity junkies, is that the U.S. labor market remains too resilient. We got more confirmation of a very robust labor market on Friday with the release of the December jobs report, which showed the unemployment rate down to 3.5%. Job growth came in at 223,000 for the month, well above the 100,000 level that Fed Chair Jerome Powell has said he would like to see to show that the labor market is slowing. Wage growth remains robust, companies are reluctant to lose employees given still tight labor market, and those that lose jobs continue to have an easy time finding new employment (even in technology).

The Fed has said it is looking to drive unemployment higher this year to slow wage growth momentum enough to ensure that core services inflation (ex-housing) can return down toward its 2% goal. Given the structural labor supply issues driven by aging demographics, work-from-home dynamics and Covid-19 impacts, the Fed will have to do even more tightening than normal to achieve this goal. It is this gap between current labor market conditions and the market’s perpetual need for liquidity that has me more concerned about risk assets in early 2023.

Stock Market Predictions 2023: The Bears Have Power

The Fed is unable, given its mandate, to address the signs of deteriorating economic momentum clearly visible in the economy. While the underlying strength of the U.S. economy and firm wages help Main Street, Fed tightening is the death knell for Wall Street.

Without incremental liquidity coming, the stock market is greatly at risk. Investors need to be cashed up awaiting better entry points before redeploying capital into risk assets. I will need to see the Fed’s success in slowing down Main Street’s wage gains before believing Wall Street can resume its place as the favored side.

I expect a rocky start to 2023 and I am set up risk-off with long position in gold and short positions on equity indices.

On the date of publication, Craig Shapiro did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

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