While higher rates should lead to some softening in economic activity, CIO believes the US economy will avoid a recession. (UBS)

The interest rate decision itself was in line with expectations—the Fed kept the range for federal funds rate unchanged at 5.25–5.5% and left the door open to hiking one more time before the end of the year. However, the central bank also released projections from FOMC participants that indicated a shallower path of rate cuts in 2024 and 2025. As a result, the 10-year Treasury yield moved up to 4.5%—the highest level since 2007. And, in an unsettling echo of 2022, equity markets sold off. For the week, the S&P 500 fell 3%, while the Nasdaq declined 3.6%. The benchmarks are now down 5.8% and 8%, respectively, from their summer highs.


We would make the following observations:


The primary catalyst for the Fed’s “higher for longer” view is a stronger-than-expected economy. The Fed upgraded its expectations for economic growth and lowered projections for the unemployment rate over the next two years. It did not change projections for inflation. This is an important distinction from 2022, when Fed rate actions were mostly dictated by higher inflation.


While higher rates should lead to some softening in economic activity, we believe the US economy will avoid a recession. Business and consumer balance sheets are healthy, there are 1.4 jobs available for every unemployed person, real wages are rising, and there are no obvious areas of over-investment in the economy. But with oil prices higher, student loan payments restarting, excess consumer savings dwindling, and mortgage rates up, we do expect economic growth to slow. This should limit further increases in long-term interest rates. We expect them to fall from here.


With respect to equities, we would keep the recent moves in context. Even including the decline from the summer highs, stocks are still up nicely this year with year-to-date gains of 14% for the S&P 500 and 27% for the Nasdaq. Second, while one more hike of 0.25% is plausible, the Fed is likely very close to the end of its rate hiking campaign. And, as always, the Fed will be data dependent. The market currently thinks the Fed will cut rates at a quicker pace than the FOMC projections. If inflation cools fast enough, the market will probably be correct.


Third, earnings revision momentum has been improving all year and analysts have actually been raising forward earnings estimates since the summer. This is a stark contrast to the negative earnings revision momentum—and outright earnings cuts—last year. We think too many investors focused on the surge in rates last year as the key driver of equity market downside.


Last year’s poor earnings revisions were primarily driven by a decline in profit margins from unsustainably high levels in 2021 and a moderation in activity in industries that were key pandemic leaders (e-commerce, digital advertising, PCs, housing, etc). With margins now at more normal levels and signs of stabilization or improvement in segments that were weak in 2022, the downside risk to earnings expectations does not look large, assuming the economy doesn’t slip into a recession.


With the recent pullback in stocks, for the first time in many months, the risk/reward in equities is starting to become more attractive. In the very short term, stocks may continue to drift lower. But in light of indications that corporate profits should continue to improve, the downside risks do not appear large. Upcoming inflation readings and then the third quarter earnings season (which starts in about three weeks) will likely be important equity market drivers. We retain both our neutral allocation to global equities and most preferred view on bonds in our tactical asset allocation. Our December 2023 and June 2024 S&P 500 price targets are 4,500 and 4,700, respectively.


Main contributors - Solita Marcelli, David Lefkowitz


Original report - Higher for longer, 26 September 2023.