Fed Rate Hikes, Inflation, and the Risk-Reward of Equities

In response to inflation surging last year, the US Federal Reserve has raised interest rates from nearly zero to almost 5% within the past year.[0] This is intended to help curb price growth and encourage saving over spending and investing. However, while higher rates can help control inflation, they can also crimp demand and sap economic growth.

The risk-reward for equity markets is poor due to these higher rates, as the monetary policy remains in restrictive territory in the context of an earnings recession that has now begun in earnest. With inflation falling, speculation has arisen that the Fed could halt its rate hikes in the foreseeable future or even start cutting them later this year.

The Labor Department reported last week that the US added 517,000 jobs in January, crushing the 185,000 consensus nonfarm payrolls estimate from economists surveyed by Bloomberg.[1] The US unemployment rate dropped to an unprecedented 3.4%, the lowest it has been in over half a century.[0]

Marko Kolanovic, a strategist at JPMorgan Chase & Co., said he is “turning more defensive” on stocks, recommending that investors should fade the stock market rally of 2023 because “a recession is currently not priced into equity markets.”[2] He warned that markets are overpricing recent good news on inflation and are complacent of risks.[2]

Inflation as measured by the consumer-price index ran at a 6.5% rate in the 12 months through December, according to a report from the Bureau of Labor Statistics last month.[3] The expectation is for this rate to slow further in January, but if it does not, it could suggest the Fed may have a harder time taming inflation than experts believe—a development that would likely further rattle markets.

Wharton professor Jeremy Siegel expects stocks to soar and house prices to slump in the months ahead, with inflation eventually returning to 2%.[4] He also said he would prefer the Fed pause its rate hikes, as there is enough evidence that prices are down.[5] Despite this bearish outlook, Siegel still expects the Dow Jones Industrial Average to climb 18% to 40,000 points by 2025.[0]

Kolanovic echoed this sentiment, arguing that an economic downturn will eventually be necessary to bring inflation back to central-bank targets and said the potential upside for markets is likely “fairly limited,” given stretched valuations and high rates.[2]

0. “Wharton’s Siegel: strong US jobs data may hit stocks, lead to recession” Markets Insider, 6 Feb. 2023, https://markets.businessinsider.com/news/stocks/wharton-siegel-jobs-report-economy-stock-market-outlook-fed-recession-2023-2

1. “Stock Market Just Made The ‘Same Mistake Again’—Here’s Why Experts Are Worried About The Latest Rally” Forbes, 13 Feb. 2023, https://www.forbes.com/sites/jonathanponciano/2023/02/13/stock-market-just-made-the-same-mistake-again-heres-why-experts-are-worried-about-the-latest-rally

2. “It’s time to become defensive with stocks and ditch them for bonds because a recession is coming, says JPMorgan’s top strategist” Yahoo Canada Finance, 14 Feb. 2023, https://ca.finance.yahoo.com/news/time-become-defensive-stocks-ditch-104519897.html

3. “‘Edge of a swamp’: JPMorgan strategist sees ‘one time only sale’ in fixed income as U.S. economy slows” MarketWatch, 7 Feb. 2023, https://www.marketwatch.com/story/edge-of-a-swamp-jpmorgan-strategist-sees-one-time-only-sale-in-fixed-income-as-u-s-economy-slows-11675774251

4. “Wharton’s Siegel: Stocks will keep surging, house prices will tumble” Markets Insider, 9 Feb. 2023, https://markets.businessinsider.com/news/stocks/jeremy-siegel-wharton-stocks-house-prices-market-outlook-predictions-fed-2023-2

5. “Morgan Stanley says the stock market is ‘disconnected from reality’ and it’s going to hit bottom this Spring” Fortune, 13 Feb. 2023, https://fortune.com/2023/02/13/morgan-stanley-stock-market-downturn-bottom-this-spring-disconnected-from-reality/