• Bank of America thinks the Federal Reserve will raise interest rates 11 times in 2022 and 2023.
  • That’s more than most investors expect, but BofA says it won’t derail the market or the economy.
  • The firm’s equity strategists explained the sectors they think will do best as rates head higher.

Bank of America’s new interest rate forecasts are more severe than expected, but the firm says it’s going to turn out better than investors think.

In late January the bank predicted that the Federal Reserve would raise interest rates seven times this year and four more times in 2023 in order to bring the benchmark US rate to 2.75%.

Bank of America’s prediction is far higher than the three rate hikes the Fed anticipated in December 2021 and the four hikes Goldman Sachs expects this year. And according to CME Group, Bank of America expects two or three more rate hikes than the futures market does.

“It does sound extreme on first blush,” Savita Subramanian, the firm’s head of US equity & quantitative strategy and ESG research, said during a media event on Monday.

Ethan Harris, Bank of America’s head of global economics, explained that the combination of trillions of dollars in stimulus funds, low interest rates, and a very tight labor market is fueling a lot of inflation. So the Fed will have to keep raising rates to keep that inflation under control.

"The economy's not just hitting the Fed's goals, it's blowing through the stop signs," he said. "The unemployment rate's still falling steadily, inflation has moved well above target and is likely to stick above target, even as supply constraints are removed."

That sounds like it's more than enough to put a dent in economic growth, and with it, the stock market. But Subramanian says those seven hikes won't even be enough to get US rates to a neutral level, which means it won't slow the economy.

More importantly, she says, higher rates are ultimately positive for many stocks, and they're certainly better for the stock market than rampant inflation would be.

"The real thing that hurts the markets is not the number of hikes the Fed does, it's the message they send," Harris said. He explained that the Fed plans to raise rates at the gradual pace of 25 basis points per meeting, which won't cause much pain. But what investors would have more to worry about is if the Fed said it was going to raise rates dramatically because inflation was getting out of control.

Subramanian says the bigger issue for stocks is that the Fed's balance sheet is shrinking. The tightening of conditions paves the way for only modest returns for stock indexes, and she expects the S&P 500 to finish the year at 4,600 — about 2% above its current level, but lower than where it started the year.

She says investors should stay ahead by investing in cash-earners.

"If I were going to think about one metric I would use to pick stocks this year, it would be free cash flow yield," she said, adding that many financial and healthcare companies fit the bill. "Even big technology companies are starting to look more attractive with a little bit of volatility, and we're seeing these opportunities still within the energy sector," she said.

In a separate note, Bank of America strategist Jill Carey Hall added that among smaller and mid-size companies, the industry groups that have tended to perform best when investors prepare for the Fed to get hawkish include semiconductor chip and chip equipment manufacturers, entertainment, air freight and logistics, and construction materials.

"Semis has typically fared best," she said. "A number of industries within Industrials (Air Freight & Logistics, E&C, Road & Rail, Machinery) have also been among the historically outperformers in a hawkish Fed backdrop. Meanwhile, Utilities, Staples, and Telecom stocks have been among the typical underperformers."