Are Equity Investors Ignoring Economic Realities?

After a volatile first quarter, U.S. stock and bond markets have been telling differing stories. Equities, for their part, have rallied off their recent lows, clawing back more than half of the losses from the S&P 500’s recent correction of more than 10% and the Nasdaq’s bear-market drawdown of more than 20%. U.S. Treasuries, in contrast, continued to suffer deep losses, with yields rising and two- and 10-year rates inverting, stoking recession fears. 

What’s underpinning the recent resilience of U.S. stocks? Simply put, equity markets appear to be betting that the Federal Reserve can successfully guide the economy to a “soft landing” as it rapidly tightens policy to tame inflation. In addition, many investors seem to be shrugging off the prospect of rising inflation-adjusted, or “real,” interest rates, as well as new complexities emanating from the Russia-Ukraine conflict and other macroeconomic headwinds. 

Morgan Stanley’s Global Investment Committee disagrees with these sanguine views and believes some of the more cautious signals coming from the bond market may better reflect the likely path ahead. In particular, we point to three areas of concern:  

1. Execution risk is high as the Fed rapidly tightens policy. Over the past three months, futures markets have gone from pricing three Fed rate hikes to pricing nine, which would raise the benchmark rate to 2.5% later this year and 3.5% next year. What’s more, minutes from the Fed’s March meeting suggest the central bank may cut up to $95 billion a month from its asset holdings, about $15 billion more than recent consensus expectations. Such aggressive tightening will make the Fed’s policy execution highly complex, and historical examples suggest that even when the central bank does manage to land the economy softly, markets often feel a much harder impact.


2. Rising interest rates could start to weigh on equities. Many investors today appear to believe the recent rise in interest rates will be short-lived and that real rates will remain negative, which could support higher stock valuations. This may be wishful thinking. We believe the Fed is apt to tighten policy more than many investors expect, impacting real rates and valuations as a result.  


3. Macroeconomic headwinds continue to build, and the handful of mega-cap growth names that dominate passive benchmark indices today may not be impervious to such challenges. They include:

• Rising costs for companies, including labor, logistics, distribution, energy and other industrial commodities

• A shift in consumption away from goods toward services that could see consumer demand normalize

• Slowing U.S. economic growth, as signaled by declines in new-orders data

• The growing potential of recession in Europe amid the Ukraine-Russia war

• New COVID-19 lockdowns in Asia, which are heaping more pressure on already-strained global supply chains

As financial conditions tighten, a strong but slowing economy is unlikely to be enough to power substantial passive index gains from here. We look for risks to get more rationally priced and believe investors should watch earnings-revision trends for confirmation that index-level and mega-cap tech profits are not immune to the forces of reality.

We recommend investors neutralize big over- or underweights in asset allocation and hew to goals-based target allocations, with emphasis on active managers who are focused on quality factor attributes.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 11, 2022, “A Tale of Two Markets.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.