Have Markets Finally Adapted to Higher Rates?

Markets may have finally gotten the message that the U.S. Federal Reserve is planning to keep rates higher for longer.

Since 2021, the Fed has cautioned investors that inflation could prove sticky and that the central bank will steadfastly keep interest rates higher as needed to bring inflation to a heel. However, many investors didn’t heed this message, believing instead that monetary policy would quickly ease and U.S. stocks would continue moving higher.

Stocks’ extended selloff following September’s Federal Open Market Committee (FOMC) meeting may indicate that the Fed’s message is now loud and clear. The S&P 500 and Nasdaq indices ended last week down 2.9% and 3.6%, respectively, with both on pace for consecutive monthly declines for the first time in a year. Government bond yields, meanwhile, surged to their highest levels in more than a decade, as investors reassessed the likelihood of higher-for-longer rates.

Why Investors Paid Attention

At first glance, the central bank did exactly what markets had predicted: It held interest rates steady. But Fed Chair Jerome Powell’s press conference and the “dot plot,” which illustrates officials’ rates projections, offered a few perspectives that differ materially from investors’ previous assumptions.

For one, policymakers suggested at least one more rate hike is likely, and that 2024 would bring probably no more than half a percentage point worth of cuts—a disappointment to markets whose consensus view just the prior week was for one whole percentage point of cuts next year.

In addition, the central bank underscored that:

• While inflation has thus far come down faster than expected, core inflation around 4% is still far from the Fed’s target, and a strong labor market makes further inflation progress uncertain.

• GDP growth for 2023, previously forecast at about 1%, is now expected to be more than twice that. Further, 2024 growth is estimated at 1.5%, higher than previously predicted. With growth stronger than anticipated, pressure remains for rates to stay higher.

Higher Rates Call for Active Strategies

Investors may have gotten used to the very low interest rates of the past decade or so, which helped drive stocks higher. When all else is equal, lower yields increase the value of a company’s future earnings in widely used pricing models and therefore should boost stock valuations.

But now, investors will have to adjust to higher rates, which may make equities less attractive compared to safer fixed-income investments. This environment favors active stock selection over passive index-level investing.

Keeping in mind that individual investors’ circumstances will vary based on their goals and risk tolerance, now may be a good time to balance equity exposure in a portfolio between offensive and defensive stocks. Given that broad U.S. stock indices are likely to trade in a fairly static range for the next few quarters, portfolio diversification may become all the more important.

Finally, the fourth quarter may be a good time to consider using any losses on municipal bonds, preferred securities or Treasuries to help offset capital gains elsewhere in your portfolio for tax purposes, a process known as tax-loss harvesting. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 25, 2023, “Preserving Optionality?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.