Buckle Up For The December Fed Meeting: 2 Scenarios Playing Out

Summary

• Our playbook for the upcoming December Fed meeting.
• The major stock indexes are back to their all-time high, brushing off recent Omicron concerns and broader macro uncertainties.
• The upcoming Fed meeting will be critical because it could signal a more hawkish shift in policy to address surging inflation.
• We expect continued volatility in stocks with the Fed moving forward with a rate hike in 2022 despite a slowing economy.
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It was a kumbaya moment for stocks this week posting a massive rally amid easing Omicron concerns. Headlines suggesting mild symptoms from the variant while vaccine makers signal that the current shots provide protection helped the Nasdaq-100 (QQQ) surge by over 5% from last week's lows while the S&P 500 (SPY) is back to within 1% of its all-time high. That said, it's time to start thinking about next week's December Fed meeting which has the potential for fireworks. The real issue is surging inflation that may approach a 7% annual rate when the latest CPI report is released Friday.

All this follows the November payrolls data which raised questions regarding the momentum in the economy even before the latest Omicron fears and new Delta variant surge. It's a good bet that the December payrolls trend will be even weaker into a critical moment where the Fed is being forced to turn hawkish. In our view, there is nothing bullish about the current environment under the following two scenarios:

• If macro indicators start underperforming, expect revisions lower to the growth outlook, along with pressure on earnings across sectors.
• On the other hand, if Covid disruptions are "over" and Omicron is indeed a nothing-burger, the setup is for inflation to continue surprising to the upside through 2022.

There is a real risk of a broader economic slowdown just as the Fed enters a tightening phase. Next week, the Fed will need to walk a thin line by assuring the market inflation is under control while holding the narrative of the ongoing "post-pandemic" recovery. For stocks, the risks remain tilted to the downside.

The November Payrolls Report Was Ugly

The 210k jobs added in November were a massive miss compared to expectations of the economy adding 550k workers. While the report can be cherry-picked highlighting a tick lower in the unemployment rate to 4.2% along with the cumulative 5.6 million jobs added over the past year, the context is important and ugly in our opinion.

Looking back, June and July were very strong for jobs capturing the early "reopening" trend with many service sectors companies most impacted by the pandemic rebuilding headcount. In August and September, soft jobs data at the time was blamed on the Delta-Covid surge, forcing companies to push back on rehiring plans back. Favorably, a strong rebound in October with+546k jobs coinciding with declining Covid cases that month supported a view that the U.S. had finally turned a corner.

(source: tradingeconomics.com)

Besides Covid, the other major development this year has been the rising inflation trend. The last reported October CPI at +6.2% was the highest level in over 30 years also reflecting multi-year highs in energy prices. There is a thought that companies recognizing the trend of rising costs are taking a more cautious approach to expansion plans to protect margins and profitability explaining some of the recent weaknesses. Putting it all together, the market was simply too optimistic about NFP in November. Here's our take:

• Most companies among pandemic-impacted industries like travel, leisure, hospitality have already rebuilt headcount since "reopening".
• Companies are starting to hold back on hiring with an eye on costs and expenses as a result of inflation trends.
• With the pandemic theme of efficiency, companies may be realizing they just don't need as many workers for the same level of productivity.
• The underlying strength of the economy is weaker than it appears.

Again, what's more concerning is the outlook for the December payrolls and into Q1 2022. The last few weeks have been defined by a new Covid surge beyond the Omicron headlines, and it's hard to see a big boom in hiring taking place right now.

Inflation Is the Problem

The latest November CPI data is due this upcoming Friday, December 10th. The current consensus is for a y/y reading at +6.8%, while the final number may even be higher. Heading into 2022, there is a sense now that the inflation trends are structural and not simply based on a weak year-over-year comparison period.

(source: tradingeconomics.com)

The challenge with inflation is that it ends up building upon itself with relative "stickiness" of prices. From the boost to demand based on the all-in approach to pandemic stimulus, the cycle will keep going unless put in check through the Fed's primary tool in hiking rates. While supply chain disruptions going back to production stoppages since 2020 have contributed to some temporary price dynamics, companies see the higher input costs across the energy and raw materials, end up raising prices to keep up.

Indeed, one of the themes during the Q3 earnings season was messaging in many industries for plans to move forward with more price hikes through next year. There is little reason to expect prices for goods and services consumers are buying to start rolling back. The baseline now is that the Fed must and will hike.

A High Stakes FOMC

The next Fed meeting announcement is set for Wednesday, December 15th. While the consensus is for the headline fed funds rate to remain are zero, the market will look for clues regarding the Fed's positioning into 2022.

Importantly, Fed Chairman Jerome Powell during comments to Congress already went so far as suggesting it was time to retire the word "transitory" seeing the trends deeper and more long-lasting. We expect the messaging this month to include a recognition of the latest Covid resurgence that continues to add uncertainties. There is also some room for the statement to tone down the overall economic optimism compared to comments in the last FOMC which cited strengthening "indicators of economic activity and employment".

What we'll be watching is the movement of the "dot chart" as to the trajectory of a future rate hike expectation along with revisions to the official economic forecast. In September, the Fed released its updated economic projection for indicators across U.S. GDP growth, unemployment, and inflation. At the time, the headline was that the group was revising lower its outlook for 2021 GDP to 5.9% from 7.0% while bumping its forecast for 2022 GDP to 3.8% from a prior 3.3% estimate. The group was also considering one 25 basis point rate hike in 2022 to "0.3%" and effectively another three rate hikes in 2023 taking the Fed Funds rate to 1%.

(source: Federal Reserve Bank)

Here's our take on what to expect for the December update:

• We'll bet that the official projection for GDP is lowered for both 2021 and 2022, citing the ongoing Covid situation and softer data more recently.
• 2022 and 2023 inflation "Personal Consumption Expenditure - PCE" gets revised higher recognizing the non-transitory aspect.
• The unemployment rate estimate gets bumped a few ticks higher.

The bigger question is in the update that will be made to the single data point for the 2022 Federal funds rate, with massive implications for the investing outlook. Taking a "hawkish" approach, that 0.3% figure implying one rate hike could transform into 0.5% or even 0.8% implying two hikes or three hikes in 2022. The other possibility is that the Fed "blinks" and keeps that projection for 2022 flat at 0.3%, essentially doubling down on an expectation that inflation will begin to trend lower. Both of these cases have bearish implications for stocks.

1. A more aggressive rate-hiking path: Perceived as negative by taking away the main tailwind for stocks responsible for positive gains over the past two years. Here the market could begin to question if higher rates through 2022 will undermine the strength of the economic recovery particularly if it is accompanied by a revision lower to GDP.
2. Fed errs on the side of caution: By keeping only one 2022 rate hike on the table, this risks inflation expectations becoming "unanchored" while moving the market against risk assets because it implies even more uncertainty.

Our FOMC Playbook

The well-intentioned efforts to provide accommodative financial conditions have in part led to the inflation quagmire that now threatens broader economic stability. By the market and the Fed not seeing eye-to-eye on how the economy will progress over the next several months, the strategy to deal with inflation can end up failing.

A good example is the trading action in energy prices including crude oil (USO). There was a thought that the Omicron variant causing new economic disruptions would have a silver lining of limiting near-term inflationary pressures providing some flexibility for the Fed. With oil rallying sharply off the lows and already back towards $75 per barrel, the expected relief through lower gas prices may only be marginal. Similarly, interest rates all over the place reflect this confusion.

(source: finviz)

Again, it's an extreme level of uncertainty on various fronts and we believe that will be translated into stock market volatility. Our view is that the economic recovery is beginning to show cracks which is a completely new dynamic compared to the trend of better-than-expected data since the second half of 2020.

With the major indexes back to near an all-time high, following what has already been a spectacular year for returns, it's a poor time to stay aggressively bullish. The outlook for 2022 is still too optimistic likely requiring adjustments lower to earnings either because the Fed is going to tighten more aggressively or the underlying economic strength is slowing. The setup here is for another leg lower in stocks. We view the technology sector including the NASDAQ-100 (QQQ) as most exposed to these headwinds because high-growth momentum type names will continue to be sensitive to both interest rates and changing growth estimates. Looking at the QQQ ETF, we believe it can retest the $350 price level to the downside over the next several months, with the mega-caps underperforming.

(source: finviz)

Finally, we mentioned the dovish scenario where the Fed is at least less-hawkish than expected. Notable, we believe this would be very bullish for gold (GLD) as it was widening the spread between inflation expectations and interest rates, thereby leading to a more negative real yield. We see upside for precious metals into 2022, representing a store of value and inflation hedge, also benefiting from a weaker Dollar which can reverse the recent strength. For gold, a break higher above $1,850 would likely open the door for a larger move towards $2,000 and the previous all-time high near $2,100 as the metal regains momentum.

(source: finviz)

Disclosure: I/we have a beneficial long position in the shares of GDX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.