According to Morgan Stanley Wealth Management, investors should “resist chasing knee-jerk rallies” in stock markets as it is uncertain whether the Federal Reserve will be able to secure a soft landing for the economy while combating hot inflation.
“It may be premature to bet on an economic soft landing and therefore a bullish outlook for equities,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said in a statement Monday. “The big question: will consumers keep spending if their views on real income don’t improve soon?”
While annual wage growth has risen by nearly 6% amid a tight labor market, “household estimates of their real incomes are shrinking,” according to Shalett.
Read: Can a Bag of Grocery Drop Stocks? Wall Street interferes as Fed tightens financial conditions
How consumers choose to spend “will have a profound impact on both growth and inflation,” she said. The potential for a “revival in services consumption” and a fall in demand for goods could lead to “negative earnings surprises” for companies as they rebuild inventories amid the pandemic, she said.
Last week, the Fed raised interest rates by 25 basis points from near zero and signaled its intention to make another six hikes this year to rein in high inflation. Further hikes would take the rate to 2.8% in 2023, according to the median forecast by Fed officials.
While “markets initially welcomed the Fed’s determination to fight inflation,” Shalett viewed the “central bank’s admission that inflation and world events are likely headwinds to growth” as more worrying. Fed officials cut their forecast for US economic growth this year to 2.8% from a “robust” 4%, she wrote.
“Paradoxically, the stock market rallied, ignoring the growth outlook downgrade,” Shalett said. “Investors need to lower expectations and resist chasing knee-jerk rallies.”
Meanwhile, the bond market sees “increased chances of policy error” from the Fed, she said, pointing to the flattening of the US Treasury yield curve. “Even among Fed governors, there is little debate about the central bank being ‘behind the curve’ in fighting inflation,” Shalett wrote.
Read: The US Treasury yield curve risks a reversal relatively early after the start of the Fed’s tightening cycle, Deutsche Bank warns
All three major US stock benchmarks closed lower on Monday after Fed Chair Jerome Powell said in a remark to the National Association for Business Economics that “inflation is way too high” and the door was open for a rate hike by more than opened 25 basis points if necessary. The Dow Jones Industrial Average DJIA,
closed 0.6% lower while the S&P 500 SPX,
slipped less than 0.1% and the Nasdaq Composite COMP,
fell 0.4% according to FactSet data.
In his speech on Monday, Powell also noted that history shows that it is possible for the economy to achieve a “soft landing” if the Fed tightens monetary policy. He said the central bank raised the federal funds rate “significantly” in 1965, 1984 and 1994 without triggering a recession.
Investors have watched the yield curve for inversions because historically this has preceded a recession. The 2-year to 10-year Treasury yield curve spread traded around 18 basis points on Monday, flattening from around 0.30 basis points on March 15 Federal Reserve Bank of St Louis.
The yield of the 10-year Treasury note TMUBMUSD10Y,
rose to 2.315% on Monday, a 52-week high, while the yield on 2-year Treasury note TMUBMUSD02Y,
climbed to a 52-week high of 2.132%, according to Dow Jones Market Data.
According to Shalett’s note, investors should consider adding US Treasuries and investment-grade bonds “to hedge against stock market volatility.”
“We believe that US Treasury yields are approaching theoretical cycle peaks and that value is gradually being restored,” she wrote. “As the yield curve flattens, the upside for long-duration rates could be more limited as policy action offsets higher inflation expectations.”
the core inflation rate, without food and energy, was up 6.4% in the 12 months to February based on the consumer price index, according to data released by the US Bureau of Labor Statistics. That “searing” rate of inflation came when “the fed funds rate was 0%, a policy gap last observed in 1974,” Shalett said.
Including food and energy, the consumer price index rose to 7.9% on a 12-month basis in February, the highest level since January 1982.
“We are skeptical that rate hikes alone will be enough” to fight inflation, Shalett said. But “the potentially more important part of the required policy mix – balance sheet shrinking and liquidity siphoning – has yet to be determined and its implications for markets and the economy are unclear.”
Read: What happens to money when the Fed starts shrinking its balance sheet?
The Fed’s plans to trim its balance sheet as part of what it calls “quantitative tightening,” which Shalett said is likely to be announced in May. U.S. economists at Morgan Stanley expect quantitative tightening to start at $80 billion per month in mid-2022, with about $500 billion in balance sheet contraction by year-end.
“As measured by the tightening, that’s another 25 basis point hike,” Shalett wrote in the note. “By contrast, from 2017 to 2019 the balance sheet loss totaled $700 billion before the Fed stopped as markets plummeted and stocks sold off.”
Uncertainty about how much “liquidity deprivation” the market and economy can take before “it starts to pinch” increases risk, which she notes “should be compensated for” by lower stock market price-to-earnings multiples.
“With its credibility on the line, the Fed has turned hawkish at a particularly challenging time for the global economy,” Shalett said. “Recent aggressive guidance on rate hikes and clear concerns about inflation point to rising chances of a policy mistake as the central bank is forced to tighten amid global slowdown conditions.”