Investors Shouldn’t Count on Cooling Inflation Yet

Although the S&P 500 just wrapped up its fourth losing week out of the last five, stock investors remain too complacent about the strength of equities overall. That may be a mistake. 

Despite recent inflation numbers, and the likely additional Fed rate hikes, stock valuations continue to be elevated, with forward price/earnings ratios staying within a tight range. Yet, typically, valuation multiples should weaken when monetary policy tightening drives up interest rates. Consider that Treasury rates have risen significantly, in apparent anticipation of further tightening, with the yield on the 10-year now at 3.46% and the real, or inflation-adjusted, yield approaching a four-year high at 1%. 

Moreover, the stock-market volatility index (or VIX), which tends to rise with market uncertainly, has also remained relatively stable. Although it currently sits slightly above its long-term average, the VIX is within its past two years’ trading range. In comparison, the bond-market counterpart, called the MOVE index, has recently doubled, approaching a level last seen during the March 2020 COVID crash. 

Why the relative resilience in the stock market? 

While potential explanations abound, it’s most likely that equity investors are engaged in wishful thinking, believing that the Fed will soon rein in inflation and start cutting interest rates again. This perspective helped drive the rebound in stocks for most of July and part of August. It’s a view we continue to reject. To the contrary, we believe the inflation fight is far from over, especially given last week’s disappointing August inflation report, which underscored that inflation is still rising, broad-based and potentially more entrenched than previously thought:

• The August numbers dashed investor hopes that inflation had finally peaked, with the headline consumer price index unexpectedly rising 0.1% from July and 8.3% from a year earlier. The “core” metric, which strips out volatile food and energy prices, gained a higher-than-expected 0.6% from July and 6.3% year-over-year. 

• The data also highlighted how persistent inflation is. Even as prices for energy and goods have fallen, services-based inflation—including “sticky” components such as housing and wages—continues to keep price pressures strong, as consumption patterns shift from goods back to services amid easing COVID concerns and restrictions.

• Finally, service-sector inflation is broad-based. Within the wide-ranging services categories—including rent, physicians’ services and motor vehicle insurance—about 70% of the categories registered inflation rates above 4%. 

While monthly data can certainly change, we think inflationary pressures will continue for longer than the equity market is forecasting. That gives the Fed plenty of ammunition to continue tightening and suggests that now is not the time for equity investors to be complacent. 

In fact, the stock market is likely to face further downward pressure and retest June lows. Investors should be cautious when considering long-duration or growth-oriented stocks, therefore, which face headwinds from rising real rates and the strong U.S. dollar. Instead, look for fairly valued dividend stocks.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 19, 2022, “Higher for Longer.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.