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Investors Looking for Interest Rate Peak

More inflation surprises and the U.K. market crisis show how changes to the interest rate outlook can quickly move markets. Chief Investment Strategist Jim McDonald analyzes what these changes mean to investors and the global economy.

  • Crisis in the U.K.
  • Recession Probabilities
  • Look to Earnings for Potential Support

We expect elevated volatility to continue as long as investors remain uncertain about how high interest rates are going. Higher than expected inflation reports in recent months have triggered that uncertainty again, pressuring stocks and bonds and increasing the risk of recession in the US. With an eye on current inflation and no way to forcast inflation, the Federal Reserve is likely to continue its aggressive hiking campaign at least through early 2023. Let's take a look.

Significant and abrupt changes in monetary policy can have a dramatic impact, not only on financial markets but also economic activity. One only has to look at the difficulties in the UK bond market in recent weeks. The combination of a mishandled budget proposal by the government, along with actions by an inflation-fighting central bank, led to a crisis for UK pension plans. This crisis and concurrent turmoil in the bond markets sparked a dramatic intervention by the Bank of England and an embarrassing u-turn by the prime minister.

While the UK pension market has unique characteristics, which includes much greater leverage in use of derivatives than in the US, the negative reaction to the jump in interest rates is a warning sign. Globally, the surge in interest rates is already hurting economic activity, as home prices are starting to fall. Homeowners with variable rate mortgages, which is more prevalent outside the US, face higher monthly mortgage payments along with rising energy costs.

We think recession in Europe is nearly assured and see no better than a 50/50 chance of a US economic soft landing. We also expect Chinese growth to continue disappointing, as the property sector struggles and the Zero-COVID policy hampers a recovery. We may changes to our tactical asset allocation policy this month in our global policy model.

Because we expect global growth to disappoint and monetary policy to keep tightening, we expect volatility to remain high. In this environment, we are underweight equities and investment-grade bonds, and overweight high-yield bonds, and modestly overweight cash. Solid third quarter earnings could provide some support for stocks. But clarity on the peak fed funds rate, along with the resulting economic outlook are probably necessary for a more constructive outlook on risk taking.

Jim McDonald

Chief Investment Strategist
Jim McDonald is an executive vice president and the chief investment strategist for Northern Trust. He is responsible for overseeing the strategic and tactical asset allocation policy for our institutional and wealth management clients globally.