Inflation’s path will drive the stock market next year. Here’s one firm’s playbook.

Analysts at 22V Research led by Dennis DeBusschere have set out a playbook on how the market will react. They note that the Fed expects core PCE — 3.5% year over year as of October, with new data out Friday — will fall to 2.4% by the end of 2024.

In the first scenario, growth remains above the 2% trend, wages take longer to disinflate and core PCE tracks a bit over 2.4%, but not above 2.75%.

In that setup, the Fed would still cut rates, perhaps not by three or four times, though, says 22V. That would favor deeper cyclicals — energy, materials, industrials — “or make them tougher shorts,” and also make it tough to short the U.S. dollar or bet on U.S. Treasury yields declining, they say.

A second scenario would see core inflation tracking above 3% — Treasury yields and the U.S. dollar
DXY
would move higher, and risk-off factors would benefit, they predict.

Under a third scenario, inflation would head to 2.4% well before the end of 2024. That would mean four to five Fed rate cuts, more downside risks to the dollar and Treasury yields and further easing in financial conditions.

“Stocks do very well assuming we move below 2.4% on core PCE WITHOUT an increase in the unemployment rate,” they say.

22V’s broader message though is that the companies that have lagged, like small caps, should continue to catch up.

“Into year end we are not concerned about a sharp pullback, but with the VIX
VIX
sub-13, credit spreads in their 18th %tile (very tight), the S&P [price/earnings] over 19.5 times, and investors sentiment (AAII) in its 98th percentile, the scope for further S&P gains is narrowing. Internals rotations remain a better way to play for gains into year end,” said DeBusschere and the team.

Read: This is a good time to invest in a bond fund. One manager has an advantage over his largest competitors.

The markets

Stock futures
ES00,
-0.20%

YM00,
-0.14%

NQ00,
-0.29%
are drifting south, with bond yields
BX:TMUBMUSD10Y

BX:TMUBMUSD02Y
dropping and tracking U.K. yields
BX:TMBMKGB-10Y
after a sharper-than-forecast fall in inflation for that country. The pound
GBPUSD,
-0.63%
is taking a hit on that.

The buzz

FedEx stock
FDX,
-0.68%
is dropping after the package-delivery giant cut its full-year sales forecast over worries about subdued demand for holiday shipping.

Tesla
TSLA,
+2.04%
has reportedly told some employees it will not grant merit stock awards this year.

Read: Investor who called year-end stock rally says ‘Magnificent 7’ may continue to lead in 2024

Alibaba
BABA,
+2.13%
CEO Eddie Wu will take over the Chinese internet group’s e-commerce business.

The NYSE is suspending Farfetch shares
FTCH,
-13.26%
over a liquidation warning.

U.S. current account data for the third quarter is due at 8:30 a.m., existing home sales and consumer confidence are expected at 10 a.m.

A divided Colorado Supreme Court barred former President Donald Trump from the state’s presidential primary ballot citing an insurrection clause. Trump’s attorneys say they will appeal.

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