Just weeks ago the Standard & Poor’s 500 Index and the Dow Jones Industrial Average were at new highs for the year – three-year highs, in fact. Just two weeks later, after declining roughly 5%, both averages are down year-to-date. Rising interest rates and rising oil prices are finally impacting equities as well. The S&P 500 yesterday closed at 1,183.78, the Dow at 10,565.39, and the Nasdaq at 2,007.51.

Energy stocks have been the leader this year. Combined with the other two sectors that are up, materials and utilities, that represents less than 15% of the equity market. Not including these three sectors, the S&P is down 7% year-to-date, so it has been a narrow participation in terms of the winning category. Rising interest rates and oil prices, as well as a projected loss at General Motors and concerns about lowered quality of that credit, caused some selling in high-yield and emerging-bond markets.

Energy stocks, up again last week and up 20% year-to-date, are the subject of debate. In the short term, a lot of money has gone into the sector and the stocks are up fairly significantly. That is always cause for concern about a pullback. But long term, they still represent less than 10% of the total market capitalization. That is to say that on a longer-term basis, it does not seem overly extended.

Further evidence of deterioration in breadth was the 128 new lows on the New York Stock Exchange this week. Breadth seems to be narrowing as the bull market continues to mature.

One of the keys to understanding energy is China. Growth there seems to be moving higher again. China reported this past week that industrial production was up a double-digit amount, suggesting perhaps that China will bring about more efforts to slow its economy. Our view is still that real growth in China will be nearly as strong as last year.

In the fixed-income markets, Treasury rates remain firm with a 10-year Treasury yield just above 4.50% and Fed expectations of 3.25% by the month of June. The Fed meets this week and is widely expected to announce another 25 basis point increase. The question is whether the Fed will remove the word “measured” in terms of its pace of increase. It would make sense to expect a change in language soon, since economic growth has remained fairly strong, and it appears the Fed is generally more concerned about the potential for higher inflation than lower inflation or economic slowdown viewing that the output gap is not very large.

In terms of inflation, while we believe there are still global deflationary forces, near-term cyclical risks exist. Record-high energy prices, rising commodity prices, strong internal (domestic) demand and the weaker dollar point to higher inflation levels.

The Fed’s tightening so far this cycle has been less effective than in the past, we believe, because until recently we have gotten a favorable reaction from the bond market. That source of support reversed recently. We believe a still more aggressive Fed and further increases in bond yields will be needed in order to slow economic growth and, more importantly, chill inflationary expectations.

We expect an eventual mid-expansion economic slowdown as occurred in the 1980s and the 1990s. We think this concern about inflation and some of the excesses in asset markets will cause the Fed to increase rates. This causes us to be neutral at best in the near term around long-dated financial assets.

Mr. Doll is president and chief investment officer of Merrill Lynch Investment Managers.