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Will Investor Optimism Hit a Fed Wall?

Oct 18, 2023

Investors may need to reevaluate three key assumptions driving confidence for lower rates from the Fed.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Investors are optimistic the Fed will lower interest rates based on anticipated economic growth, cooling wages and tightening financial conditions.
  • However, the Fed may continue to see good reasons for keeping rates high so they can prevent sticky inflation.
  • Investors should weigh their lofty expectations with the Fed’s cautious stance when making portfolio adjustments. 

Investors who consider a clear descent to lower interest rates a foregone conclusion could be underestimating the cloud of inflation that has increasingly obscured the path to a “soft landing” for the economy. 

 

Some equity investors optimistically point to recent declines in inflation as reason to believe the Federal Reserve will soon begin cutting interest rates, with the ultimate hope of returning to the pre-pandemic era of slow growth, low rates and cheap money, which supported higher stock valuations. In this soft landing scenario for the economy, resilient growth powers double-digit gains in corporate earnings from the third quarter of 2023 through 2025, according to current Wall Street analyst consensus.

 

Not so fast. We believe the Fed’s progress in taming inflation has stalled out and that Fed officials know it. There have now been three straight months of inflation rate increases since June’s 3% annual rise in the consumer price index (CPI). Amid persistent inflation, we believe there is a growing likelihood the central bank will keep a tight grip on monetary policy to choke off growth and create slack in a still-tight labor market.

 

Here are the three drivers of investors’ optimism—and why we believe a soft landing may not be assured. 

  1. 1
    The economic growth forecast

    Bullish stock investors foresee a soft landing scenario that features 12% compound annual growth in corporate profits through 2025 alongside falling inflation and reaccelerating “real,” or inflation-adjusted, economic growth. That scenario seems highly unlikely. Relatively loose monetary policy could fuel economic growth, but it would also leave room for inflation to stay elevated. On the flip side, corporate cost-cutting could support profitability but would likely lead to lower economic growth, higher unemployment and a weaker consumer. Either way, expectations for such an optimistic scenario stand in contrast with the Fed’s current focus.

  2. 2
    Cooling wages

    What about the labor market? Investors point to slowing hourly earnings growth as a potential cue for the Fed to ease its grip on monetary policy. However, we believe the Fed sees a job market that is still hot, especially given last month’s surprisingly strong job openings numbers and payrolls. Consider that prime-age labor participation has already surpassed pre-pandemic levels, and aggregate participation is a solid 62.8%. In addition, initial weekly unemployment claims are still averaging an exceptionally low 225,000 per week, half the five-year average. If the Fed wants to tackle inflation by reducing wage pressure, it still has work to do.

  3. 3
    Global financial conditions

    Financial conditions have finally started to tighten. Some equity investors may take resurgent oil prices, a strong U.S. dollar and the recent run-up in long-term Treasury yields as potential reason for Fed hawks to back off on rates. However, this ignores the fact that the Fed typically waits for market variables to finish tightening before it considers cuts. As they are still in the process of tightening, Fed cuts could still be many months away. 

How to Invest

While the market expects double-digit earnings growth through 2025, the Fed has clearly signaled that it is still focused on slowing down growth. While investors remain optimistic, betting against the Fed is rarely a long-term winning strategy. Instead, investors should expect the market to trade sideways for a while as U.S. growth and labor dynamics continue to drive Fed policy.

 

In equities, consider reducing exposure to any extreme sector or factor over-weights and seeking a balance of offensive and defensive stocks, with a focus on quality. In fixed income, investors may want to rebalance portfolios towards intermediate duration investments that offer value and historically high yields. Now may also be a good time to “harvest” any investment losses for tax purposes in municipal bonds, preferred securities or Treasuries.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 16, 2023, “Fighting the Fed.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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