Markets need 'Fed to be done, inflation back below 3%' to begin trading to upside: Strategist

Baird Investment Strategy Analyst Ross Mayfield joins Yahoo Finance Live to discuss how the stock market is performing while contending with inflation and the ongoing debt limit dilemma.

Video Transcript

AKIKO FUJITA: Joining us now is Ross Mayfield, Baird Investments Strategy Analyst. Ross, I want to pick up on the conversation we had before the break. We were talking about the impact the debt ceiling discussions, especially if we go past that x date, what that's likely to mean for the markets. It feels like the markets are kind of taking that in stride right now.

ROSS MAYFIELD: It does. We're trading at the top end of a range that we've been stuck in for a while, but better than expected earnings. The market has been buoyant. And it hasn't really been reflecting those debt ceiling concerns or, really, even much of the concerns about the banking crisis yet.

We kind of stand in the arena where we think something gets done. But, like the Evercore analysis mentioned earlier, oftentimes, it's market volatility that draws policymakers to the table. I don't know if it's that they need to feel it a little more viscerally to kind of reinforce what would happen if something like this were to come to pass, but I do think, like 2011, that volatility in the market will be the catalyst.

But it might take until kind of the final deadline to get that done. So I think over the coming weeks, you mentioned short term Treasury yields spiking, those might continue to rise. But I think especially in the equity markets, some heightened volatility and downside skew is likely.

SEANA SMITH: So, Ross, you mentioned that volatility in the market might be the catalyst here in order to get congressional leaders to reach an agreement. What's going to be the catalyst, though, for the market to get it out of that 3,800 to 4,200 range? Is it a debt ceiling deal? Or does it need to be something else?

ROSS MAYFIELD: I'm not sure that it's the debt ceiling that's holding the market either up or back. I mean, obviously, if you break through the debt ceiling and default on the debt, that might be the catalyst to the downside. We don't think that's very likely. I think the one thing to remember is that markets can trade in these ranges and can trade kind of flat to sideways with some chop for really long, extended periods of time.

We're not always in an ascendant bull market and we're not always in these terrible bear markets like 2022. So I think that in this kind of interim period where rates are a little sticky, inflation is a little sticky, but earnings are hanging in there, the consumer is proving resilient, I wouldn't be surprised to see us trade in this range or kind of bouncing around in this area for maybe longer than would be comfortable for most investors.

I think to break out to the upside, you need the Fed to be done, you need inflation to be back below 3%, and you need to show that there wasn't widespread economic damage outside of what might already be expected from the market. So that'll take time for the market to get that data and feel comfortable with that outlook. So, again, we could be here for a while.

AKIKO FUJITA: Ross, we've got about 85% of the S&P 500 companies already reporting. I mean, it was sort of negative going into the earnings season, but things have kind of improved. I mean, you could argue that expectations were so low, given the macro environment. But I wonder what stood out to you so far in terms of what we've heard from the companies and what that tells you about where we're headed.

ROSS MAYFIELD: Yeah. I think you're right. I mean, earnings had certainly been de-risked by how negative things had gotten. But I do think that the number one thing you're seeing is that companies and corporate operators are finally starting to get a really good handle on how to operate in this macro environment. You saw that with all the upside surprises and all the beats above the one and five year averages, which is really impressive considering what we were looking at a couple of years ago.

And then even on the guidance side, things haven't been super rosy, but they're not as dour as you might expect given higher interest rates, Fed hiking, debt ceiling looming, banking crisis unfolding. Guidance was, as far as negative guidance, was actually better than the long term averages. So I think it's just a case of corporate operators finally getting a better handle on things. I think inflation has improved really dramatically, especially on the raw materials side of things.

And I think labor shortages and labor problems are of falling by the wayside as the labor market softens as well. So not quite as negative. And yeah, you really like to see the upside surprise here to start the year out right.

SEANA SMITH: Ross, what does all this mean for Fed policy? Because if you take a look at the swaps, they are still suggesting that we could at least see a half a point cut before the end of the year. Yet you had the teams at Goldman and at Barclays coming out betting against rate cuts before the end of the year. What do you think is likely on the table?

ROSS MAYFIELD: I think the Fed does not want to cut. They've come out of basically every opportunity and said, we're not going to cut. We want to hold higher for longer. We might not even be done hiking.

I think they should be done hiking. I'm not sure they should have hiked the last meeting. But irregardless, they want to be higher for longer until inflation is back towards that 2% target.

What the market is anticipating, in my assumption, is that inflation will come down faster than expected. But more likely than not, that's something like this banking crisis will lead to a harder landing than the Fed anticipates. They don't think there will be no economic pain, but they're certainly still preaching the soft landing scenario.

We think that's possible. The consumer has been really resilient. But the market, I think, pricing in rate cuts in the back half of the year is seeing something a little gnarlier and something that the Fed will have to deal with by cutting rates.

So it's really up to, in my opinion, at this point for 2023, does the banking crisis lead to a dramatic slowdown in lending at small and mid-sized banks? And what does that do for employment at small and midsize companies? We'll find out soon.

I think some of the data that's coming in suggests we're going to see a slowing there. And the Fed may have to cut. I think they'd be loathe to, but they might have to.

SEANA SMITH: All right, Ross Mayfield, always got to-- always great to get your perspective-- Baird Investment Strategy Analyst.