3 Reasons for Caution in Today’s Markets

As it begins to raise interest rates to slow inflation, the Federal Reserve has expressed confidence that it can achieve a “soft landing” for the economy. Investors appear to be buying it.

While bond markets are sending mixed signals, equities have continued to rise since the Fed raised rates by 25 basis points in mid-March. Major U.S. stock indices are back to roughly where they were in early February, erasing recent losses around the Russia-Ukraine conflict. Importantly, the nature of the rally has shifted, as “short covering,” a technical move that typically leads to sharp gains, has given way to something more fundamental: growing investor risk appetite, as told by the options market.

These developments indicate markets may be counting on a “Goldilocks” scenario, where policymakers tame inflation with limited damage to economic growth and keep long-term rates low by historical standards.

We don’t think such market confidence is warranted. Here are three reasons:

• Stocks appear overvalued. Earnings yields are low and price/earnings ratios are high relative to historical trends when considering prior periods of higher-than-expected inflation. Specifically, over the past 70 years or so, when the Consumer Price Index ran between 6% and 8%, S&P 500 price/earnings ratios averaged about 12. Today, that multiple is about 20. By another measure, the return premium that equity investors get for taking on risk appears low today, despite a litany of new and increasing risks including a maturing business cycle and ongoing geopolitical strife.

• Markets may not be effectively pricing the impact of the Fed’s balance-sheet reduction and liquidity withdrawal. The Fed has yet to announce details of such plans, and already U.S. financial conditions have begun to tighten and are back to pre-COVID levels. Consensus expectations say the Fed will drain at least $560 billion over the rest of 2022, an action that would be equivalent to another quarter-percentage-point rate hike. As we have commented before, the Fed has limited experience with these operations and execution risk is high. Remember the Fed quickly aborted its 2018 balance sheet run-off when markets responded with heightened volatility.

• Lastly, market perceptions of the Fed’s resolve may be off. Investors seem to be looking for the “Fed put,” when policymakers limit market declines by easing monetary conditions. This hope may be misplaced, given the Fed’s recent hawkish rhetoric, with governors acknowledging a need to move more aggressively on tightening, including the possibility of half-point rate hikes, as opposed to the typical quarter-point ones. It’s possible that some of this positioning may be politically driven, but there is growing potential that the central bank will need to prioritize taming inflation over backstopping markets. In fact, the Morgan Stanley economics team now projects rate hikes of 50 basis points in both May and June.

Ultimately, rather than a policy cycle that is short and sweet—and that continues to buoy passive indices—we envision a bumpier path, where policymakers are at least forced to acknowledge the degree of difficulty in executing the soft landing some investors expect.

In the meantime, investors should consider using rallies to take profits in passive indices and redeploy assets toward active managers, looking to build a balanced portfolio with growth companies at reasonable prices. Also consider Treasuries, which we believe are now trading closer to near-term fair value. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 28, 2022, “If Only.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.