Investors should watch the Nasdaq 100 and Chinese stock markets to know if the Fed will pull off a soft landing for the economy, says Fundstrat's Tom Lee

• Investors are keenly focused on whether the Federal Reserve can stick a soft economic landing amid high inflation and rising interest rates.

• To gauge the Fed's progress, investors should watch the performance of the Nasdaq 100 and Chinese stocks, according to Fundstrat.

• "The relative strength of Nasdaq 100 and China equities argues for 'soft landing' not recession," Fundstrat said.

Investors should closely watch the performance of the Nasdaq 100 and Chinese stocks to gauge whether a soft economic landing is possible, according to a Friday note from Fundstrat's Tom Lee.

The Federal Reserve is stuck between a rock and a hard place, as chairman Jerome Powell attempts to tame high inflation without sending the US economy into a recession.

That dynamic has led to a volatile stock market, as investors are keenly focused on either inflation wrecking the economy, or a recession sparked by higher interest rates hurting the economy.

"But these are not the only two paths for markets, even if markets see these as most probable," Lee said, pointing to a third outcome.

That third path is a soft economic landing, meaning that the Fed is successfully able to tame inflation by raising interest rates without throwing the economy into a recession.

"Instead of a recession vs inflation debate, it should be [a] 'soft' vs 'hard' landing [debate]," Lee said, adding that a soft landing would give more room for the S&P 500 to recover its recent year-to-date losses of nearly 20%.

And right now, it looks like a soft economic landing is happening, according to Lee, who pointed to the recent relative outperformance of the Nasdaq 100 and Chinese stocks. The Nasdaq has been outperforming broader markets since early June, while Chinese stocks have been outperforming since April.

"These two markets bear watching. After all, a recession would be a massive headwind for QQQ and China equities, surging inflation would be a headwind for QQQ and China. But a soft landing would arguable be a positive, since this would signal Fed potentially shifting dovish," Lee explained.

And it wouldn't take much for the Fed to turn dovish if supply chain logjams begin to ease, as Powell told Congress about the possibility of a "sharp decline in prices."

"In situations of unusually tight supply and demand, prices move far more than suggested by typical models. In excess demand, prices rise faster. In easing supply, the prices could move lower," Lee explained.

And with the market pricing in year-over-year CPI reading of 9% through November, any lower reading could reset inflation expectations and increase the chances of a soft landing.

"To the extent incoming inflation is softer than consensus, we could see these measures adjust downward sharply. This would be positive for risk assets," Lee concluded.

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