Why Portfolio Construction Could Get Tougher

We are just a few weeks into the new year, and the market environment is challenging investors to rethink their expectations. Not only are investors realizing that monetary policy tightening is inevitable in 2022, but also that the Federal Reserve is willing to raise interest rates earlier, faster and, importantly, concurrently with a large balance-sheet reduction.    

This has already driven interest rates up significantly and led to heightened stock-market volatility, underpinning one of the biggest market rotations in years away from rate-sensitive, long-duration growth-style stocks toward value. 

But will this be a lasting shift for the market?

Many analysts see a familiar scene playing out: There was a rapid run-up in rates in the first quarter of 2021, followed by a steady decline that lasted well into the summer This latest increase in rates, they surmise, could prove fleeting as well. Their logic? Inflation is probably reaching a peak as supply-chain disruptions ease and the Omicron wave of the pandemic subsides, potentially easing upward pressure on longer-term rates. They think the yield curve will flatten, as it did in 2021, and that this cycle will see rates stay low alongside disappointing economic growth.

In fairness to this view, there have been signs that inflation is peaking. Inflation expectations have been stable recently, the pace of U.S. factory activity expansion has slowed, and China’s factory prices have increased at a lower-than-expected rate.

But overall, the Global Investment Committee at Morgan Stanley disagrees that we’re seeing a repeat of 2021. As noted in our 2022 outlook, we believe economic growth and inflation will be structurally higher, supporting higher rates. Here are three more reasons we see interest rates moving higher:

• First, the U.S. Fed is not alone in pivoting away from easy policy. Global short-term rates have been climbing for nearly a year, with 92 central banks moving off their pandemic-era maximum accommodation, according to Cornerstone Macro. The all-important German bund, for instance, recently saw its 10-year yield rise from deeply negative territory to near-zero, its highest level in almost three years. Broad policy tightening around the world has helped reduce the global pile of negative-yielding debt to $10 trillion for the first time since April 2020.

• Several central banks could soon start shrinking their balance sheets in a process known as “quantitative tightening.” Morgan Stanley & Co. analysts expect the Bank of England, the Bank of Canada, the Reserve Bank of New Zealand, the Swedish Riksbank and the Reserve Bank of Australia to join the Fed in the unwind sometime in 2022. A slimming balance sheet is an outright reduction of liquidity, which should impact local asset prices and hit the cost of capital. 

• Lastly, relative U.S. dollar weakness persists. The dollar has been on a downtrend in recent weeks, even as rates have been climbing. Rising rates and expectations of more aggressive policy tightening should typically support a currency, but this doesn’t appear to be happening with the dollar today. This may indicate a peak in the dollar’s value relative to other currencies, and traders may be anticipating a decline in the U.S.’s relative growth and yield advantage versus other markets, particularly Europe, Japan and emerging-market countries. A weaker dollar generally means higher inflation for longer, which could lead to higher rates.

All these factors complicate portfolio construction. As investors face reduced market liquidity, expensive mega-cap tech stocks are still vulnerable to another pullback. The rotation toward cyclicals and value, while likely sustainable, could become challenging if policy tightening coincides with organically slowing growth and inflation.

Investors should expect a volatile market that demands some defensiveness and a focus on companies that can deliver positive profit surprises as well as dividends and buybacks. We are again emphasizing active stock-picking in this environment and encourage investors to re-tool their portfolios for greater diversification by region, style, sector and market cap. Lastly, those looking to deploy new cash should be patient. There will be a time for opportunistic re-entry into tech highflyers, just not today.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 18, 2022, “Reckoning with Regime Shifts.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.