Will Q4 Bring an End to the Bear Market?

Investors seem to be without clear direction after the Federal Reserve’s third straight interest-rate hike of 75 basis points, combined with its surprisingly hawkish forecast for more hikes in coming months.

Meanwhile, conflicting signals from economic data are compounding investors’ uncertainty. On one hand, leading indicators, such as Treasury yield curves, suggest the increasing likelihood of a recession in the year ahead. Inverted yield curves, which occur when long-term debt has lower yields than short-term debt of similar quality, indicate that bond investors are pessimistic because they expect long-term interest rates to decline, which is generally associated with recession. For example, the 2-year/30-year curve is the most inverted it has been since 2000, with 2-year Treasury yields 51 basis points higher than 30-year Treasury yields. 

On the other hand, however, lagging indicators such as retail sales, manufacturing-activity gauges and labor-market data suggest potential resilience in third-quarter earnings results and a pickup in economic growth. 

Stock investors may be underestimating the leading indicators, while putting too much weight on the lagging ones. Morgan Stanley’s Global Investment Committee believes this bear market is far from over and recommends investors consider three key dynamics to inform their equity investments going forward.

• The Fed’s resoluteness: The U.S. central bank is on one of its most aggressive tightening paths; it has never raised rates this quickly in a nine-month period. But over the past 13 years or so, investors grew used to very low interest rates and a patient, if not outright supportive, Fed. This has left many stock investors today underestimating the central bank’s resolve to raise rates. And in turn, the market’s continued expectation of a dovish pause or a pivot by the Fed has pushed Chair Jerome Powell to reiterate his conviction via strong rhetoric and aggressive forecasts.

• The persistence of core inflation: The headline consumer price index was up 8.3% year-over-year in August, a slight deceleration from the 8.5% pace observed in July, due in part to declining commodity prices. And the September reading, as projected by the Federal Reserve Bank of Cleveland, could inch down to 8.1%. But core inflation—the Fed’s particular focus—was higher than expected and is unlikely to abate anytime soon, given strong price pressures coming from the services side such as wages and rents, which tend to be slow to change. If core inflation stays higher, so will interest rates.

• Policy lags: The impact of monetary policy on the economy and corporate profits comes with long lags. Current levels of growth in the national gross domestic product and, in turn, third-quarter corporate earnings reflect where interest rates and financial conditions were nine to 12 months ago. This means investors could be getting a false sense of security from whatever earnings potential they see in stocks today.

Simply put, the paths for interest rates, inflation and corporate profitability all remain uncertain. That’s why stock investors should be demanding a greater premium for taking on risk. In other words, stocks still look expensive, and valuations look high, especially given that inflation-adjusted yields have moved up. 

Investors could be in for more surprises as they continue to overlook the impact of tightening financial conditions. They should be cautious about investing in long-duration or growth-oriented equities, which currently may not offer fair compensation for the risks of rising rates, weakening operating leverage and the strong U.S. dollar. Any bear-market rally that may occur in the seasonally strong fourth quarter should be used for rebalancing portfolios and tax-loss harvesting.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 26, 2022, “Leads and Lags.” Ask your Morgan Stanley Financial Advisor for a copy.