The end of summer has brought renewed weakness to global markets. Both equity and bond markets broke through June lows, driven by the outlook for Fed policy. Fed Chair Powell’s speech at Jackson Hole in August threw cold water on the market’s hope that the Fed would consider pausing its tightening cycle. As a result, bond markets have ratcheted up their expectations for this cycle’s terminal interest rate from 3.3% at the end of July to 4.5%1. This has amplified concerns that the Fed will ultimately drive the US economy into a recession to push inflation lower. The shift in the outlook for US rates also has led to a spike in the dollar, which has tightened global financial conditions. The European energy crisis, along with China’s zero-Covid policy and real estate crisis, are further downside risks to global growth.
Exhibit 1. Market implied US overnight lending rate (based on Fed funds futures)
1 Source: Bloomberg, as of September 29, 2022
Yield curve effects
The outlook for a higher terminal Fed Funds rate has rippled through the yield curve, with the 10-year Treasury yield briefly reaching 4% in late-September, its highest level since 2010. The Bloomberg Aggregate bond index is down 14% year-to-date, an unprecedented drawdown for the index. The MSCI ACWI index is down 25% in 2022 as higher interest rates have weighed on equity valuations2. The decline in equities so far this year can be explained by the rise in interest rates.
Exhibit 2. 2022 global equity market performance
2 Source: Bloomberg, Refinitiv, as of September 29, 2022
Inflation Outlook: Looking ahead, the outlook for inflation and its impact on Fed policy likely will remain the key driver of the markets’ direction. Encouragingly, inflationary pressures appear to be easing. Some of the temporary factors driving inflation have begun to turn over. In particular, the significant decline in energy prices from their peaks in the US should lead the headline inflation rate lower in the coming months. In addition, the gradual easing of supply side constraints and weaker demand should slow core inflation. While it remains to be seen if this will be enough to lower inflation to the Fed’s target, it does hint that Fed hawkishness could be near the peak and terminal rate expectations (currently at 4.5%) have limited upside from here.
Economic Growth Outlook: Nevertheless, the Fed’s efforts to stamp out inflation have affected economic growth. US economic activity has been nearly flat in 2022 and the tightening of financial conditions are only just beginning to be felt. Rates on mortgages and car loans, for example, rose substantially over summer. The drag likely will intensify into 2023, increasing the risk of at least a mild recession. The good news is that household balance sheets remain strong, which should cushion household spending and prevent a deep downturn. Further, employment might not be impacted much even in a mild recession. With current openings exceeding those seeking work, companies can cut back on new hiring before cutting back on existing jobs. This could provide downside support for consumer spending. In contrast to a typical economic cycle, stagnant growth or a mild recession that reduces inflation could prove supportive of the equity markets. The prospect of the Fed halting rate increases and a fall in longer-term interest rates could more than offset the negative impact of weak earnings in a mild recession.
However, history suggests that soft landings have been difficult for the Fed to achieve. There is a chance of a deep recession if the Fed overshoots. While much of the equity market decline has been driven by rising interest rates and shrinking P/E multiples, a significant recession that hits earnings would bring further declines in equities and would lead to greater challenges in the credit markets.
The biggest downside risk for balanced portfolios we see is if inflation remains sticky even as the Fed slows the economy. The case for this scenario rests on the tight labor market, which could keep upward pressure on wages and risk a wage-price spiral. Moreover, the health of household balance sheets might prove a double-edged sword. Demand could stay too strong even as financial conditions tighten, requiring a more forceful Fed response. Should that occur, it could take a deep recession to increase unemployment enough to ease inflation. This likely would result in continued weakness in stocks and bonds. However, we think this is a less likely outcome at this point.