Investors Worry Higher Interest Rates Might Sink Stock Prices Further

A person on the floor of the New York Stock Exchange (NYSE) watches TV screens on July 27, 2022. (Timothy A. Clary/AFP via Getty Images)

Investors have lost more than $7.6 trillion on U.S. stocks this year, and experts are warning that the losses could mount heading into 2023.

From institutional investors to retail traders, it’s been a challenging year to navigate the worst-performing market in five decades, Bespoke Investment Group says.

“It is no secret that 2022 has not exactly been the year of the 60/40 portfolio,” the group wrote in a research note in August, referring to a portfolio of 60 percent stocks and 40 percent bonds. “This year has left nothing safe with both stocks and bonds hit hard.”

The Nasdaq is parked in what Wall Street calls a bear market—when prices fall 20 percent or more—as the tech-heavy index is down nearly 30 percent year-to-date. The S&P 500 Index also fell into a bear market, sliding about 22 percent on the year. On Sept. 26, the Dow Jones Industrial Average, with a decline of 1.1 percent, became the last of the major U.S. stock indexes to fall into bear territory.

By comparison, when President Joe Biden took office in January 2021, the markets had rallied significantly from their bottom in March 2020, when COVID-19 was declared a pandemic. The Dow had climbed about 61 percent, the S&P 500 had rallied roughly 67 percent, and the Nasdaq spiked close to 97 percent in that span. These indexes then reached their peaks in late 2021.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York on Sept. 7, 2022. (Brendan McDermid/Reuters)

With the third quarter coming to an end, the Dow is poised for a 7 percent loss, while the S&P 500 and Nasdaq are each on track for a more than 6 percent drop.

What’s Driving the Markets?

The three biggest drivers of this downward market have been surging inflation, aggressive monetary policy tightening by the Federal Reserve, and growing concern about global recession.

Despite the summertime rebound, market analysts say that the market bounce is over.

“There’s no reason this (stock) market can’t fall much further,” Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments, told Morningstar. “If history is any guide, the market could easily go down another 10 percent to 20 percent.”

Ray Dalio, the billionaire founder of Bridgewater Associates, reiterated that position, suggesting higher rates could further sink equity prices.

“I estimate that a rise in rates from where they are to about 4.5 percent will produce about a 20 percent negative impact on equity prices (on average, though greater for longer duration assets and less for shorter duration ones) based on the present value discount effect and about a 10 percent negative impact from declining incomes,” he stated in a Sept. 13 LinkedIn post.

The Fed raised interest rates by 75 basis points during the September Federal Open Market Committee (FOMC) policy meeting, lifting the benchmark federal funds rate to a target range of 3 percent to 3.25 percent. According to a summary of economic projections by rate-setting committee members (pdf), interest rates could rise 4.4 percent by the end of this year and then to 4.6 percent in 2023, before easing to 3.9 percent in 2024 and 2.9 percent in 2025.

There had been some expectation that the central bank would pull the trigger on a full-point increase following a hotter-than-expected August inflation report. For now, Mimi Duff, the managing director at GenTrust, notes that investors are pricing in a peak federal funds rate of 4.6 percent around May 2023 as they digest the “higher for longer” messaging from the inflation-fighting Fed.

Instead of ultra-hawkish rate hikes, the Fed “is trying to look as tough as possible,” Christian Hoffman, a portfolio manager and managing director at Thornburg Investment Management, wrote in a note.

“I wouldn’t be surprised to see Chairman Powell enter the next meeting wearing a leather jacket and sporting a neck tattoo,” he wrote. “The Fed is willing to continue hiking through 2023 even if it means weaker growth and rising unemployment.”

Stocks in the 4th Quarter

What does this mean for stocks in the final few months of 2022? It will be all about the data.

The FOMC’s economic projections show that officials think the unemployment rate will reach 4.4 percent next year, and that gross domestic product (GDP) will run at an anemic 1.2 percent pace in 2023.

Following two consecutive quarters of negative GDP growth rates, which indicates a technical recession, the U.S. economy risks running another quarter of subzero GDP.

The Federal Reserve Bank of Atlanta’s GDPNow estimate was slashed to 0.3 percent on Sept. 20, from a projected high of 2.6 percent on Sept. 1. Investors keep a close eye on the GDPNow model, which predicts GDP growth.

According to Deutsche Bank economists, investors will be paying attention to the final second-quarter GDP reading, the latest initial jobless claims, and the August personal income and spending data. They will be released later this week.

“In summary, Fed officials and market participants will get plenty of data to inform their views on the economic outlook. However, given the Fed’s recent rhetoric, much of it is likely to play second fiddle to the inflation data,” the financial institution explained in a note. “Continued upside surprises to inflation could lead to a peak fed funds rate exceeding 5 percent, particularly if it occurs in conjunction with easier financial conditions and a persistently tight labor market.

“Conversely, a faster decline in inflation coupled with tighter financial conditions and some loosening in the labor market, could beget a terminal rate closer to 4 percent. At this point, we see risks skewed in the hawkish direction.”

Federal Reserve Board Chairman Jerome Powell speaks during a news conference in Washington on Sept. 21, 2022. (Saul Loeb/AFP via Getty Images)

Both the Fed and the financial markets will be in “information-gathering mode at this point,” Duff noted.

“[The] Fed needs inflation lower and the jobs market closer to balanced,” Duff said. “A lot of wood to chop on both fronts, so we need to see how the real economy evolves.”

Looking ahead to the home stretch of 2022, stock market forecasts are mixed. Morgan Stanley’s Michael J. Wilson anticipates that “lows for this bear market will likely arrive in the fourth quarter.” The S&P 500 could slump an additional 13 percent to about 3,400 in the final three months of 2022, he told Bloomberg in an interview.

A Reuters poll of strategists in August revealed that the S&P 500 would end the year at 4,280. This would mean the broad measurement of stocks would need to rally about 16 percent in the final quarter.

Goldman Sachs slashed its new 2022 year-end S&P 500 target to 3,600 from 4,300, citing climbing interest rates.

In the end, “the soft-landing fairytale”—lowering inflation without causing economic pain—is “rapidly evaporating on Wall Street,” Scott Anderson, the chief economist at Bank of the West, said in a note.

“Global equity markets as you can imagine are not swallowing the Fed’s message well and equity analysts on the street are furiously cutting their year-end price targets. So now is a good time to keep your head down and take some shelter as the Fed is about to start breaking our finest china.”