Higher interest rates for longer

Inflation around the world continues to be more stubborn than expected. Supply disruptions, shortages, and an unprecedented increase in money supply have launched inflation to levels not seen since the 1980s. The Federal Reserve is now laser focused on controlling inflation, even if the measures required to control inflation inflict some pain on economic conditions. While some inflationary pressures are already easing, others are not. This suggests inflation and interest rates may be higher and last longer than expected, hindering economic growth and possibly causing a mild recession.

Inflation challenges

Higher overnight interest rates should gradually slow economic activity, which will eventually aid in controlling inflation. Nevertheless, inflation is currently eroding purchasing power for consumers, and remains problematic for the Federal Reserve as inflation remains well above its 2.5% long-term target. Food, energy, and transportation prices drove inflation over the past year. Currently, shelter, a category that represents approximately a third of headline CPI, is causing inflation to remain elevated.

Energy prices remain a threat, specifically around the world where supply-chain issues and geopolitical events have sent oil and natural gas prices skyrocketing. We do think that inflation likely peaked in March, but a significant risk is that inflation comes down much slower than the Fed and markets are anticipating and/or inflation falls modestly but gets stuck at a rate well above the Fed target.

Interest rates balancing act

The Fed’s primary tool for controlling inflation is short-term interest rates. The Federal Reserve is tasked with a difficult balancing act, they must increase interest rates at a pace that curbs inflation yet doesn’t disrupt economic growth and financial markets. There is also a substantial “lag effect” for changes to interest rates to impact economic activity—higher interest rates today won’t have their full economic impact until six to nine months from now. We think the Fed will continue to hike short interest rates into 2023, peaking at 4.75%.

Historically, the peak of the Fed hiking cycle does not occur until the Fed funds rate is above the core inflation rate (which is currently 4.9%). However, the Fed will likely be executing a “step-down” strategy—hiking rates 75 basis points in November, then 50 basis points in December, then only 25 basis points early next year. This will send a message that the economy and inflation are responding to higher interest rates and will signal the possible end of the tightening cycle. We currently expect the Fed to begin easing rates in early 2024. In general, we think the yield curve will be higher and flatter for longer.

Labor market and wage pressure

Sometimes, good news is bad news in the labor market. As interest rates rise and the labor market remains resilient, it sends a message to the Fed that the economy can easily tolerate higher rates. There are some recent signs of softness in the labor market. Job openings declined by over 1 million positions recently, while still remaining above 10 million (a very strong reading).

Numerous variables point to a strong, yet tight labor market, which makes inflation tough to conquer. The quit rate, those that voluntarily leave their job, is 2.7%, off its cycle peak in late 2021, but higher than at any time in the prior two expansions. Unemployment is down to 3.5%, at the pre-pandemic low. This has led to wage pressures; average hourly earnings are up 5.0% YoY, declining slightly of late, but still well above long-term averages.

Financial markets

At the end of the quarter the S&P 500 hit a new YTD low, down 24.8%. Historically, this signals that the economy is heading into a recession. Of course, the stock market is a leading indicator and will bottom long before all the bad economic news is out. The biggest headwind for risk-based assets continues to be sticky inflation, higher interest rates and weak corporate earnings.

With the dramatic rate increases we’ve experienced, bond market returns are nearly certain to end in negative territory for 2022, particularly if inflation remains stubbornly high. However, with higher rates the forward outlook for returns has improved, and income-focused investors have begun to obtain much more attractive yields. As the Fed nears the end of their tightening campaign, we believe longer-term interest rates are nearing their peak for this cycle—setting us up for returns over the next few years in the 3.5-5.0% range.

Economic outlook

Economic activity has been resilient, 2.6% in the third quarter, however we anticipate a significant slowdown. We expect 2022 GDP to be approximately 1.7%. Higher interest rates and persistent inflation will continue to hinder economic growth. We think short interest rates will move higher to 4.50% by the end of the year. The Fed’s tightening cycle poses a direct risk to economic growth going forward—aggressively hiking rates too high or keeping rates high too long would almost certainly cause the next recession.

We think there is a better than 50% probability of a recession in 2023, forcing the Fed to end the hiking cycle, which will (theoretically) ensure a mild and short-lived recession. GDP in 2023 could be as low as 0.4%. We expect the S&P 500 to finish 2022 in negative territory, in the –10 to –15% range. Volatility will remain elevated throughout the upcoming year, but we expect positive returns for 2023.

Forecast Q4

Bond market analysis

The economic fallout from the Fed cycle

The Fed’s battle with Inflation has resulted in a rise in interest rates that most investors have never experienced. In an effort to bring down a well-entrenched inflationary surge, the Fed has hiked overnight rates by +3.00% through the first 3 quarters of 2022 (with more to come). This has surpassed the severity of the 1994 cycle, which previously marked the “worst market” most investors had ever seen during a single calendar year.

Additionally, back in the 90’s, investors started the cycle with yields significantly higher, and therefore had ample income streams to offset much of the damage that came from increasing rates. In this cycle, we started with rates near zero, so the upshift in rates has resulted in the worst total return numbers bond investors have ever seen. Broad bond indices are currently down (15.00%) for 2022—return figures significantly worse than any previous calendar year.

We believe that inflation has likely peaked, yet remains elevated, and that the Fed is nearing the end of their tightening cycle.

Interest rates work with a lag—often taking 6-9 months to have a full impact on the economy. We believe the Fed will execute three more upward movements in coming months, with overnight rates peaking at 4.75%, followed by a protracted pause through most of 2023—to let higher rates have their full impact. This is a well-telegraphed strategy, and we believe it is fully discounted in both the equity and bond markets.

If inflation eventually starts to grind steadily lower (as we think it will), we believe that we should be very near the peak in interest rates. If so, with yields of the broad bond market near 5.00%, we should have the opportunity to generate total return numbers in the 5.00% range over the next few years—which bring back bond returns we haven’t seen in well more than a decade.

High-yield markets

High-yield markets shared in the same volatility that rocked other sectors during the 3rd quarter. While posting negative returns, they managed to outperform the broad markets for the quarter. Year-to-date, high-yield has generated nearly identical returns as the broad market. With rates pushing sharply higher and the risk of a mild recession increasing, we believe we are nearing the end of the cycle for the high-yield sector and are quickly approaching the turning point for moving to an underweight recommendation.

Summary and forecast

We believe that we are nearing the end of the interest rate cycle. Fed Funds will move to 4.50% before year end, and peak at 4.75% early next year. The Fed will then go on hold to see how the rapid increase in rates affects the economy. We believe longer-term interest rates are near their cyclical highs. As inflation begins to slowly mitigate in 2023, we think interest rates will begin to move lower. The time is approaching for moving back to full fixed-income allocations and neutral duration positioning.

Equity markets

Third quarter recap

Equities saw a strong rally in July 2022 where the S&P 500 rose 9.2% on hopes of interest rate cuts from the Federal Reserve in 2023 and a soft landing for the economy. However, equity returns soon turned sharply negative in both August and September after inflation remained high and the Fed reiterated its priority to fight inflation and signaled more rate hikes were ahead, sending stocks lower and leaving the S&P 500 index down -4.9% for the quarter.

Valuations and earnings

Equity valuations started the year near 20-year highs but have since come down closer to long-term averages. While company profits have remained resilient this year, the tone of the Fed has all signs pointing to fighting inflation which puts continued pressure on valuations. With the combination of the S&P 500 Index falling 25% year-to-date and fewer anticipated interest rate hikes in 2023, we think price-to-earnings valuations can settle in the longer-term average of the 16-18x range. An active strategy that emphasizes higher quality and growth at reasonable prices is prudent given the tumultuous environment.

Corporate earnings have remained resilient but could be at risk if companies struggle to manage their costs. Despite these fears, we think corporate earnings will grow 5% in 2022 as companies experience lower input costs, cut back on spending, and raise prices. As we head into next year, we think earnings will be flat, but valuation can expand slightly as the market discounts a Fed pivot.


Unlike central banks in Europe, which are dealing with inflation driven by energy prices, the Federal Reserve is facing the challenge of a surge in consumer demand. The Fed has responded with the sharpest tightening of financial conditions in decades. Markets have swooned with the S&P 500 Index falling 25% year-to-date through quarter end. During the third quarter, equities rebounded, but the bounce was short-lived.

Investors are now reckoning with even higher discount rates that depress multiples applied to falling earnings forecasts. While we see a slowing US economy, the reality is that the degree of tightening underway will lead to slower growth. The question is how much slower? We had been optimistic that the United States could dodge a recession, but this view appears increasingly unrealistic, as rate hike expectations escalate, and inflation shows few signs of cooling.

Equity market forecast

As equities rallied early in the third quarter, the bounce was short-lived as rates climbed higher and earnings forecasts fell. In the middle of a Fed rate-hiking cycle, we expect volatility to continue. However, we expect equities to climb higher by year end, with the S&P 500 index ending the year around 4,000, based on extreme negative sentiment and positive seasonality. We also believe much of the bad news is already priced in, with the S&P 500 falling -25% YTD compared to median market declines around recessions of only -24%.

Next year could be choppy depending on the economic/earnings backdrop, but if inflation starts to ease and we see the Fed pause, the market has the potential to grind higher.

Inflation analysis

Q4 012

  • Inflation has spiked due to stimulus, supply chain disruptions and labor market shortages.
  • Some parts of inflation are softening, but all measures are well above the Fed’s target zone of 2.00-2.50%.
  • The tight labor market and rising housing costs (see below) are keeping inflation from falling as quickly as the Fed would like.
  • Interest rate increases have not had ample time to take full effect. Inflation may start to move lower more quickly as 2023 unfolds.
  • Primary Risk: Stubborn housing costs keep inflation from falling far enough—inflation gets “stuck” well above the Fed target, forcing them into another round of tightening.

Q4 02v2 3

  • The Fed breaks CPI components into two buckets, flexible and sticky.
  • The Flexible bucket contains transitory components such as food, energy, car prices, travel and apparel. Prices in this group tend to move up and down rapidly. As seen in the chart, Flexible components of inflation skyrocketed and have now begun to fall dramatically. See next page.
  • The Sticky bucket of inflation components is dominated by the cost of housing and rent (collectively referred to as “shelter”). The cost of shelter tends to move in longer trends, and changes direction slowly.
  • While the Flexible group has softened dramatically, the Sticky group (dominated by Shelter) has continued to grind higher. This component will make it difficult for inflation to move quickly lower. See next page.

Inflation and interest rates

Q4 03

  • Flexible components of inflation appear to be headed lower.
  • Oil has one of the most consistent boom/bust cycles and sits within the flexible inflation group. It spiked to $120/bl in June, then dropped to below $80/bl in September.
  • Used cars and trucks, also in the flexible bucket, have seen huge price swings. Prices spiked more than 40% year-over-year due to supply chain shortages before falling back below 8%.
  • Housing makes up the majority of the sticky inflation bucket. Owners’ equivalent rent is up 6.7% year-over-year and rising, which will likely keep inflation from responding quickly to the Fed’s recent moves. Mortgage rates are at 20-year highs, pushing affordability severely lower. Housing prices are just beginning to show signs of broad weakness.

Q4 04

  • The inflation spike has led to a historic increase in interest rates.
  • The aggressive move from the Fed is the most severe in the last 30 years.
  • Long-term rates have spiked the most since the early 90s.
  • We believe the interest rate cycle is nearing its peak. Short-term rates will rise another 1.00-1.50%, but long-term rates likely have only modestly higher moves ahead.

Interest rates and economic fundamentals

Q4 05

  • Inflation expectations display what investors (via the bond market) believe will happen to future inflation.
  • The Fed pays close attention to the 5-year forward inflation expectations, shown by the blue line. The bond market predicts that over the next 5 years the outlook for inflation is expected to stabilize around 2.00%.
  • This data shows that the financial markets believe that the current inflation flare-up is temporary, and that inflation will be stabilizing back near the Fed’s target zone.

Q4 06

  • The six-month rate of change in the Leading Economic Index (LEI) is one of our favorite recession indicators because of its almost perfect track record.
  • Historically, when the six-month rate of change crosses -3.5%, a recession is imminent. On average the economy lags by
  • Over the last few months, we got close to this threshold before finally breaking below in June and now sitting at -5.6%.
  • This leads to the assumption that we could expect some kind of recession in the first half of 2023.

Economic fundamentals

Q4 07v2

  • The labor market remains robust and is one of the few variables still waving a green flag.
  • Headline unemployment is in dark blue. You can see historically unemployment starts to move up as we head into recessions. However, the labor market has been robust, with the last reading sitting at 3.6%, not indicating a looming recession.
  • Analyzing payroll growth in light blue, you see payroll growth starts to come down as we head into recessions. In particular, the number to watch is 1%, where if payroll growth falls to 1% and unemployment is rising, it suggests we are heading into a recession.
  • For now, with payroll growth still at 3.9% and unemployment still sitting near multi-decade lows, the labor market is not indicating a looming recession.
  • However, with the labor market good news can become bad news. Meaning if the Fed hikes rates and labor markets continue to remain robust, it sends a message to the Fed the economy can handle higher rates and they will continue to raise rates aggressively.

Q4 08

  • Here we show two consumer indices; the Conference Board Consumer Confidence in dark blue and the University of Michigan Consumer Sentiment in light blue.
  • During the Great Recession, you can see both fell off dramatically. Then took more than 5 years to get back to pre-recession levels. COVID saw a similar sharp drop, but a much quicker recovery before inflation started to erode confidence.
  • Important to note that both are still going in similar directions, just different magnitudes.
  • Higher consumer confidence ties back to the labor market, where unemployment has recovered to pre pandemic levels and remains supportive of the consumer economy.
  • It’s important to note both indices moved higher last month, which supports our conclusion of the Great Slowdown, where things will slow but does not mean a recession is imminent.

Financial markets

Q4 09

  • The stock market is a leading indicator. The charts on the left provide evidence that the stock market will lead business cycle downturns and recoveries.
  • In each time period a similar pattern emerged, equity markets declined first, the economy worsened a few months later and entered a recession then equity markets bottomed while the economy was still getting worse.
  • In fact, on average stocks bottomed 4 months before recessions ended.
  • The two examples we show are not rare, the same pattern emerged as we looked through all of the most recent downturns.
  • So, while history doesn’t always repeat itself, it certainly appears that same trend could be happening again today, with the S&P 500 already falling 25% YTD.

Q4 10

  • While you often hear, “don’t fight the Fed,” it’s important to distinguish whether the Fed is hiking interest rates fast or slow.
  • Historically during fast cycles, like we’re in today, stocks can be choppy for two years after the first rate hike. While this presents a risk, it also presents a great opportunity for long-term investors to put cash to work.
  • Given we’re currently in the fastest cycle we’ve ever seen, the market has underperformed typical fast cycles as the market discounts the speed and severity of the Fed’s hikes.

Financial markets: Bull and bear

Q4 11

  • The chart on the left helps show the long-term opportunity for stocks following bear markets.
  • For example, after the market dropped -33.8% in 2020 it was followed by a bull market that returned +113%. And that’s just the most recent of numerous examples shown.
  • The transition from bear to bull markets can also be fast, and markets are already down a similar amount to what we typically see around recessions. Meaning we could be getting closer to finding the bottom (the median peak to trough decline around last 12 recessions is -24%).

Q4 12

  • We expect equities to climb higher by year end based on extreme negative sentiment and positive seasonality.
  • We also believe some of the bad news is already priced in, with the S&P 500 already falling 25% YTD while the median market declines around recessions are only -24%.
  • Next year could be choppy depending on the economic/earnings backdrop, but if inflation starts to ease and we see the Fed pause, the market can continue to grind higher.

U.S. economic market performance – Equity and fixed income

Q4 13

  • Equities saw a strong rally in July where the S&P 500 rose 9.2% on hopes of interest rate cuts from the Federal Reserve in 2023 and a soft landing for the economy.
  • However, equity returns soon turned sharply negative in both August and September after inflation remained high and the Fed reiterated their priority to fight inflation and signaled more rate hikes were ahead, sending stocks lower and leaving the S&P 500 index down -4.9% for the quarter.
  • This is now the third consecutive quarterly decline for the S&P 500 after not experiencing a quarterly decline since the depths of the pandemic in Q1 of 2020.
  • On a sector level, energy stocks continued to be one of the few bright spots, while sectors like communication services and real estate lagged with the spike in yields.
  • Inflation and an aggressive Fed are pushing rates sharply higher in 2022.
  • Higher rates are continuing to push returns deeper into negative territory. 2022 is likely to post the worst bond market returns in history.
  • Intermediate indices have performed substantially better than broad markets.
  • We believe interest rates are nearing their peak for this cycle.
  • Higher rates ensures better forward-looking returns for the next 3-5 years.

Real gross domestic product (GDP)

Q4 14

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