How to Prepare for a ‘Late-Cycle’ Economy

As we enter the last month of the quarter, we appear to be nearing the “late” stage of the current economic cycle, a phase that typically features still-positive but slowing rates of growth in the economy and corporate profitability. Following a robust, V-shaped recovery from 2020’s COVID-induced recession, this next phase for the economy could bring a marked slowdown in corporate profit growth—but not necessarily an economic contraction, where demand falls below the long-term trend. 

Yes, the Federal Reserve will probably remain hawkish on monetary policy until it achieves peak tightening, likely in September. Still, we’re seeing inflation expectations moderating and, in turn, nominal interest rates cooling. For instance:

• The 10-year breakeven rate—a measure of inflation expectations—now suggests inflation is likely to average about 2.5% over the next 10 years, down from about 3% earlier in May.

• Fed fund futures are pricing the policy rate at about 2.6% by the end of the year, down almost 20 basis points from the high about three weeks ago.

• We expect more positive catalysts to arrive by the fourth quarter as inflation likely falls and economic stimulus in China accelerates.

Also important are the expected tailwinds for economic growth, which we believe are the best in more than a decade. Among them:

• Solid corporate capital spending;

• Improving demographics as more people enter the labor market and millennials reach their higher-spending years;

• Tight labor markets that could support wage growth and consumer spending;

• Healthy balance sheets for both companies and households;

• Continuing deglobalization and decarbonization; and

• Spending in defense and cybersecurity.

This new environment most likely means new market leadership. “Stock-picking” is the watchword, as we believe we’re in the bottom of the eighth inning of this cyclical bear market, a relatively brief period of sustained price declines in which opportunities to buy assets at attractive prices could emerge.

Investors should watch for earnings expectations to recalibrate and consider adding both defense and offense in their portfolios: investment-grade credit for the former and “growth at a reasonable price” security selection, focused on companies whose stock valuations look low compared with their long-term growth rates, for the latter. Also, consider maximizing portfolio diversification by region, sector and market capitalization.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 31, 2022, “Bottom of the Eighth Inning.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.