Morgan Stanley
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How Investors Should Play the 'Hot' Economy

Mar 14, 2023

With economic data coming in stronger than expected, and inflation persisting despite Fed action, what should investors do now?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • A resilient economy may be impeding the Fed’s progress in taming inflation.
  • U.S. consumers and corporations appear less sensitive to interest rates than historically, blunting the effect of Fed tightening.
  • Relatively easy financial conditions and tight labor markets are also making it harder to cool prices.
  • In this environment, investors should continue seeking out yield- and income-generating assets.

Almost a year ago, the Federal Reserve kicked off what would become its fastest interest rate-hiking campaign since the 1980s in a bid to cool an overheating U.S. economy and tame decades-high inflation.

 

Despite the Fed’s aggressive monetary tightening, the economy today remains resilient. The U.S. growth forecast for the first quarter of 2023 is 2.65% and unemployment is near 50-year lows. This is keeping price pressures high. Headline inflation, while down from a June 2022 peak, was still 6.4% in January—more than triple the Fed’s 2% target.

 

With the economy still chugging along despite recent troubles in the banking sector, the Fed may have little choice but to eventually push rates higher than anticipated and keep them elevated for longer, increasing the odds of a recession down the road. This raises an important question: Why are the Fed’s tools not working as planned?

 

Morgan Stanley’s Global Investment Committee sees the central bank’s progress being impeded by three obstacles over which it has little control: 

  1. 1
    Financial conditions remain relatively easy

    Massive monetary and fiscal stimulus early in the pandemic fueled a rapid increase in liquidity. Year-over-year growth in M2 (the broadest measure of money supply, including currency and coins held outside of banks, checkable deposits, travelers’ checks, savings deposits, “small-time” deposits under $100,000 and shares in retail money-market mutual funds) soared to over 25% in 2021, almost 3.5 times the 60-year average. This excess liquidity has helped support consumption and created accommodative financial conditions, even after 4.75 percentage points of Fed tightening in 2022. 

  2. 2
    U.S. consumers and corporations appear less sensitive to interest rates than they have historically

    Negative inflation-adjusted rates over most of the last decade have allowed companies and households alike to shift from variable to fixed-rate financing and mortgage debt, with most rates locked in well below current Fed funds levels. This blunts the power of rate hikes to choke off spending and cool prices.  

  3. 3
    Labor markets remain structurally tight

    Job openings are still ample amid decades-low unemployment. And while corporate layoffs in tech and finance have made headlines, many companies appear to instead be “hoarding labor,” or holding onto employees as the economy slows, to avoid the expense of hiring new workers. This is all supporting further wage growth. The resulting inflationary pressure may offset any cooling from falling goods or commodities prices.

So, what can the Fed do about these challenges? Its tools are blunt and operate with delays, making the odds of miscalculation great from here. A recession would be painful, but so would the alternative: If the central bank backpedals from its 2% inflation target, it could carry even heavier costs down the road, with damaged Fed credibility driving both inflation and the cost of capital higher. To put it another way, the price of lower rates now may be higher ones in the future.

 

We believe financial conditions must tighten and the labor market must cool before the Fed can pause on monetary tightening. Investors should stay patient and maintain solid portfolio exposure to yields and income. We prefer cash, short-duration bonds and dividend growers among “growth at a reasonable price” stocks. Global dividend payors may add diversification.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 13, 2023, “The Fed’s Dilemma.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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