Why Investors Shouldn’t ‘Fight the Fed’

Is the Federal Reserve bluffing when it suggests it is willing to raise interest rates even higher to fight inflation? Many investors seem to think so.

The central bank agreed to hold rates steady at its June meeting after 10 consecutive increases, but Fed Chair Jerome Powell made clear that policymakers are not necessarily done with tightening monetary policy, indicating that inflation still “has a long way to go” to reach the Fed’s 2% target. What’s more, Fed officials’ projections suggested another half-percentage point of hikes could come later this year.

That hawkish messaging hasn’t stopped investors from sending U.S. equities higher, with the S&P 500 Index extending its year-to-date gains to about 15%. Investors have “fought the Fed” like this for months, resisting the idea that the central bank will keep rapidly tightening policy to combat persistent inflation. They have been buying up stocks and driving valuations higher on expectations of Fed rate cuts. Excitement about recent technological innovations and a fear of missing out on the stock market’s gains have only further fueled its rally.

But can the rally keep going? We are skeptical and believe investors should start heeding the Fed’s cautionary signals for two key reasons:

• First, the Fed is unlikely to risk its own credibility by stopping short of fully quashing inflation, especially after a series of early missteps, including dismissing inflationary pressures as “transitory” in 2021. Citing the start-stop errors of the Fed in the 1970s, Powell recently noted how history has rewarded central banks that have raised interest rates above the rate of “core” inflation (which excludes volatile food and energy prices). Today, core inflation is 5.3%, while the effective federal funds rate is 5.08%. And with unemployment still very low, the Fed has room to err on the side of caution and continue raising rates, knowing it can later cut them if necessary.

• Second, core inflation remains sticky, even as broader measures of inflation have eased, thanks in part to falling commodity prices. The Atlanta Fed’s wage-growth tracker has remained high at about 6%. Owners’ equivalent rent (or the amount homeowners would have to pay in rent to equal the cost of owning their homes) continues to grow around 8% year-over-year. And in what’s been dubbed “greedflation,” companies feeling the pressure to preserve profit margins, after three years of near-record earnings, may try to continue raising their prices, further adding to inflationary pressures. Considering all this, we believe the Fed is being appropriately vigilant.
  

It seems imprudent for investors to dismiss the genuine risks highlighted by monetary policymakers as they consider keeping interest rates higher for longer. In fact, the move to higher rates now may lead to a longer-term reset for the economy. Remember that extraordinary central bank intervention has kept real, or inflation-adjusted, interest rates near or below zero for 14 years. At some point, policymakers may need to normalize rates at a higher level to align with economic growth. Historically, this has meant rates floated between 4% and 6%—a range that has correlated with equity-market price-earnings ratios of 15-16, which compare with 20 today.

In the current environment of richly-valued stocks with relatively little reward for risk, we suggest investors add duration to their fixed income portfolios by investing in longer-maturity bonds. U.S. equity investors should consider diversifying, using active managers for stock selection or owning equal-weighted passive indices. We continue to believe that commodities, as well as Japanese and emerging-markets equities, are good hedges for a peaking U.S. dollar.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 20, 2023, “Still Fighting the Fed.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.