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The Fed Will Likely Cause a Recession As It Fights Inflation

Brian Sommers, CFA


Stocks Could Recover Next Year

On September 21, Federal Reserve Chairman Jerome Powell announced a Fed Funds rate hike of another 75 basis points to a 3.00 to 3.25 percent range and signaled the Fed would likely continue raising rates without pause into 2023. The stock market fell after Powell’s post-meeting comments made it clear that the Fed is prepared to tolerate economic pain to bring inflation down to its target, meaning the Fed is willing to drive the economy into a recession to tame inflation.

Fed members had previously indicated they believed that a scenario for monetary policy tightening that would only result in a modest negative impact on growth was possible. In his press conference yesterday Chairman Powell said, “No one knows whether this process will lead to a recession.” However, the evidence is mounting that suggests the Fed rate hikes will produce a recession sooner rather than later.

  • GDP growth in the first two quarters of this year were negative and forecasts for growth in the third quarter are falling steadily, yet the impact of the rate hikes still have not fully filtered through the economy.
  • Material weakness is already apparent in more interest rate sensitive areas of the economy. There has been a material slowdown in housing activity as evidenced by existing home sales data showing monthly declines for the past seven months and down 26 percent from January levels.
  • The Fed’s Summary of Economic Projections expects unemployment to rise 0.6 percentage points in 2023, to 4.4 percent. In the past, an upward movement in unemployment of more than 0.5 percentage points has been a good indicator that a recession will occur within the next twelve months.
  • A widely followed spread on the Treasury yield curve, between the 2-year and 10-year US Treasuries, was inverted by 52 basis points after the Fed meeting. When shorter-term interest rates are above longer-term rates bond investors expect growth to weaken. In the past, an inversion of more than 50 basis points has been a good indication that a recession will occur within the next six-to-nine months.

Source: Bespoke Investment Group

  • Vladimir Putin announced that Russia’s armed forces reserves would be mobilized to support the invasion of Ukraine and that Russia “will use all the means at its disposal” to protect its territory. World leaders believe Putin’s threats increase the risk of escalation to a nuclear conflict. They also raise the likelihood that Russia cuts off oil supplies to the West, causing the price of oil to shoot higher again as the global economy still struggles to regain supply chain stability.
  • Finally, there are lingering concerns about weak growth in Europe due to its dependence on Russian oil and supply chain issues related to China’s zero COVID policies.

If a recession is imminent, as these dynamics suggest, what does it mean for the stock and bond markets? Stocks will likely continue to struggle in the near term. However, the stock market typically bottoms and begins to move higher during the latter stages of a recession before economic recovery begins.

Source: Rosenberg Research

With employment still strong and inflation already moderating, there is a good chance the impending recession will be shorter in duration with less of a drop-off in growth than the average recession. As a result, the market could begin to recover as early as the middle of 2023.

It is also important to keep in mind that even if stock prices drop further this year, the level of volatility we are experiencing is not unusual. In fact, as the JP Morgan chart below indicates, while most years include a substantial intra-year drop, annual returns ended the year in positive territory 76 percent of the time. While that might not prove to be the case this year, 2023 could be shaping up to be a solid year for the stock market.

In the bond market, investors have repriced yields higher in response to the Fed’s updated projections for their policy rate in the future. As a result, yields have moved materially higher this year, and bond investments are experiencing their worst calendar year performance on record. U.S. bond yields for every major fixed income sector in the Bloomberg U.S. Aggregate Index are now above 4 percent. While price deterioration has been painful for fixed income investors, higher yields provide more income as well as greater price appreciation opportunity should economic weakness cause central banks to pivot to lower rates to support the economy.

Though the outlook for interest rates remains highly uncertain and will likely remain volatile, we believe that fixed income as an asset class looks more attractively priced than any time in the post-global financial crisis time period.

What is an investor to do in this tumultuous time? Despite the weakness this year in both the stock and bond markets, the best course of action is to maintain a long-term allocation to stocks, bonds, and alternative investments. Investors can take advantage of the volatility by rebalancing their portfolio back to their targeted allocation, which necessitates buying more of the most beaten down asset classes. This practice has proven to improve an investor’s long-term performance.

If alternative investments are not an integral part of one’s asset allocation, now is a good time to consider adding those asset classes to an investment portfolio. Alternative investments, such as hedged equity or global macro strategies, are not highly correlated to either the stock or bond markets. For investors who are Qualified Purchasers, Private Equity and Private Credit are also compelling investments, though should be kept to a reasonable allocation due to their illiquid nature. As always, investors should consult with their Financial Advisor about the suitability of these investments for their portfolios.

Most importantly, investors should not try to time the market’s rebound. Market sentiment is currently at very low levels but can change quickly and unexpectedly. The most recent example occurred this summer as investors viewed the inflation outlook slightly more optimistically and stocks rallied 18 percent from their lows in June to the middle of August. Since no one can precisely predict when stocks will rebound from their recent weakness, investors who try to time their reentry into stocks could miss out on much of the recovery in value.


The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.

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