Stocks could rally 25%, and GOP gains in midterm elections could spur lower inflation, Fundstrat says

• Stocks could rally as much as 25% as the Federal Reserve has already tightened financial conditions, Fundstrat said.
• That supports the case for a softening in Fed rate hikes, potentially boosting stocks more than the rally in July, according to a note.

Stocks could rally as much as 25%, while Republican gains in the upcoming midterm elections could spur lower inflation, according to Fundstrat's head of research Tom Lee.

While stocks have recently seen big gains, Lee noted that after accounting for inflation, the S&P 500 is still down around 30% in real terms this year — worse than the nominal loss of about 20%.

That means even if the S&P 500 rallied 20% this year to 4,600, it would still be a loss of 16% in real terms, he said, suggesting the Fed has already succeeded in its mission to tighten financial conditions and could soften its pace of rate hikes that would propel stocks further.

"This is a dramatic wealth effect loss and tightening of financial conditions," Lee said, adding that the Fed has already "won."

Meanwhile, hopes for a Fed pivot are looking more realistic after central bankers hinted at a potential pause in rate hikes. By comparison, a premature hopes earlier this year that a pivot was imminent sent stocks up 16%, he noted.

"All of this, in our view, are reasons that any equity rally should exceed that seen in July, which was the 'false dawn of a Fed pivot,'" Lee said of his forecast, noting that a 30 to 50 day rally and a rise of 20% to 25% in stocks could be store.

And midterm elections could help fuel that momentum, he added, pointing to Fundstrat strategist Tom Block's prediction that Republicans would win a majority in the House and possibly in the Senate.

GOP gains would be considered disinflationary as Republicans would be inclined to rein in government spending, and thus reduce the risk of a wage-price spiral, according to Lee's note.

Despite harrowing recession calls from other voices on Wall Street, others have also supported Fundstrat's view for a rally. Wharton professor Jeremy Siegel noted that the Fed has made a "tremendous amount of progress" on inflation and a 30% stock rally was possible in 2023, so long as central bankers don't overtighten the economy and tip the US into a recession.