How Investors Can Prepare for What’s Next

Last Wednesday, the Federal Reserve wrapped up its highly anticipated January meeting, teeing up a March interest rate hike and suggesting a potential path of rate hikes that may be more aggressive than markets had expected. The Fed’s hawkish tone sparked a sharp sell-off in stocks and sent Treasury yields soaring that afternoon. The S&P 500 Index gave up gains to close slightly negative, while the 2-year Treasury yield climbed to 1.16%, the highest since February 2020. 

In a sense, it is encouraging that investors now have some clarity on the likely starting point of the Fed’s plans. But this sort of violent reaction to a Fed press conference suggests the more profound underlying anxieties that investors need to heed.

In particular, we see signs that markets may be grappling with at least two scenarios involving a potential Fed policy mistake, both with significant repercussions for the U.S. economy and markets:

Scenario 1: The Fed does “too much, too late.” Recent extreme moves in the Treasury yield curve may suggest that the Fed’s effort to fight inflation could set off a recession. Key to this view is that the central bank is beginning to tighten monetary policy just when the economy may be slowing on its own. Evidence of that includes:

• Weaker retail sales, as higher prices and the Omicron variant drag on business activity and consumption.

• A near 10-year low in consumer confidence.

• Potential weakness in new manufacturing orders, signaled by the contribution of inventory-building to fourth-quarter 2021 gross domestic product.

• Expiration of last year’s child tax credit, which could shave $190 billion off personal-income receipts.

Scenario 2: The Fed does “too little, too late.” On the flip side, it’s possible the Fed may fail to quell inflationary pressures, given that the fed funds rate—at near zero and estimated to hit only around 2% by the end of the hiking cycle—is still far from current levels of inflation (7% year-over-year) and economic growth (6.9% annualized). Factors that could keep inflation elevated include:

• Potential for further energy-related shocks.

• Continued supply-chain pressures.

• Upward direction in wages, which could result in a wage-price spiral.

Under this scenario, economic growth runs hotter, but real, or inflation-adjusted, gains remain fleeting. Inflation begins to do real damage to the purchasing power of retiree savings, and corporate profit growth stalls out.

Either way, the Fed has suggested it will be flexible and data-dependent as it starts tightening in earnest, and its signals and market moves—especially the Treasury yield curve—bear close watching. We believe investors will need to brace for yet more volatility and lower stock valuations. We encourage investors to lean defensive in both stock and bond positions with a short-term focus and to continue to build cash for opportunistic deployment. U.S. stocks have certainly taken a beating so far this year, and their price/earnings multiples have indeed compressed, but we believe it is premature to call “all clear.” Stay patient.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 31, 2022, “Now What?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.