S&P 500 Likely to Trade in Tighter Range in 2023

With the prospect of a pause in most Central Banks' rate hike cycles, 2023 will hardly experience the same volatility as 2022 did. Still, with no short-term solution to the current macroeconomic situation, betting on an immediate V-shaped rebound seems farfetched.

I emphasize the word "pause" because the current background simply does not allow Central Banks to start easing financial conditions anytime soon.

The labor market remains strained, supply chain issues have improved more from the demand than from the supply side, commodity prices have subsided but remain well above the historical average, and — despite last year's global stock market selloff — valuations and P/E levels remain high, especially in the face of higher capital costs.

In such a scenario, even if headline inflation were to subside well below market expectations in the next few readings — which actually seems possible, given the latest batch of macroeconomic data — a pivot would almost instantly bring back all the drivers of the current crisis.

This leaves the Fed stuck between a rock and a hard place.

On the other side of the problem, a so-called 7% solution — as suggested by St. Louis Federal Reserve President James Bullard last week— also appears utterly out of the cards.

According to Bullard, the Fed would need to maintain the federal funds rate between 5% and 7% for quite some time before pivoting lower to ensure that the inflation monster is ultimately tamed from a structural perspective.

While he may have a valid point, his 'medicine'— originally applied during the 1970s inflation crisis — is likely to kill the patient in the process as it does not consider the current highly-leveraged economy and the level of government debt.

Most likely, a liquidity dry-out of such magnitude would lead to a severe economic crisis which, in turn, would result in financial issues that run much deeper than the stock market itself — i.e., a widespread housing crisis, famine, and political and social unrest.

Even as Powell states that "restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy," we know that a more profound economic crisis would push the Fed towards a pivot very quickly.

Also, the inverted yield curve needs to flatten soon; otherwise, the U.S. banking system will begin to show cracks. We must keep in mind that U.S. banks have a great influence on the Fed's decision-making, both from the political and financial sides.

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The slowing economic situation will also soon start reflecting on earnings, pushing P/E levels even higher — unless we witness a further selloff.

As we can see in the chart below, Schiller's P/E average has dropped significantly last year but remains high from a historical perspective.