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Investing Smarter as Inflation Persists

May 9, 2023

Investors who think inflation and interest rates will drop sharply this year are buying up stocks. They may well be disappointed.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Investors expecting a sharp drop in inflation and interest rate cuts this year are doubling down on equities.
  • But a tight labor market, rising business costs and a stabilizing housing market could pressure the Fed to keep rates elevated.
  • Consider income-oriented investments and defensive equity sectors such as consumer staples, energy, utilities and health care.

After more than a year of steady rate increases, the Federal Reserve this month raised interest rates by another quarter of a percentage point. Though stocks fell in the days immediately following the hike, bullish equity investors appear to have recovered their optimism.

 

Market pricing now suggests that investors believe hikes are over and rate cuts are coming, starting with four cuts in 2023 and amounting to at least 2 full percentage points over the next 12 to 18 months. This view, which may encourage investors to double down on stocks to potentially benefit from price gains, assumes that:

 

  • Inflation, currently around 5%, will rapidly fall toward the Fed’s 2% target.
  • The U.S. economy will experience a “soft landing.”
  • Corporate earnings, which are currently showing year-over-year declines in first-quarter results, will grow by 12% to 13% in 2024.

 

These forecasts stand in marked contrast to Fed guidance itself. While Fed Chair Jerome Powell hinted that the May rate hike could be the last, he left room for more, if inflation proves stubborn. Powell also pushed back against the idea of rate cuts in 2023.

 

We believe stock investors are too bullish and that recent signs of persistent inflation will likely prompt the Fed to keep rates elevated for longer. Consider that:

  1. 1
    The labor market remains tight.

    The U.S. added 253,000 jobs in April, handily beating Wall Street estimates. Wages also rose more than forecast, with average hourly earnings up 0.5% for the month and 4.4% from a year earlier.

  2. 2
    Businesses face stubborn cost pressures.

    The Institute for Supply Management (ISM), which tracks “prices paid” by companies in various sectors, saw its index for manufacturing companies rebound from 49.2 in March to 53.2 in April, the highest reading since July 2022. In addition, the ISM index for prices paid by services companies increased for the 71st consecutive month, to 59.6. 

  3. 3
    The residential housing market may be stabilizing.

    Growth in “owner-equivalent rents,” or the amount homeowners would have to pay in rent to equal the cost of owning their home, has been cooling lately. However, after a stretch of decelerating home-price growth, housing prices appear to be stabilizing. If housing prices recover or remain static, it would short-circuit the much-anticipated declines in owner-equivalent rents, which contribute significantly to the consumer price index (CPI), a widely followed inflation gauge. 

Add to all of these circumstances the regional banking sector’s troubles, which don’t look to be over just yet, and the federal debt ceiling debate, which could further complicate the calculus around financial conditions—and we have reason to believe a strategy of doubling down on equities at this time looks especially fraught. Instead, we suggest that investors focus on income opportunities in both stocks and bonds, and look to traditional defensive sectors such as consumer staples, energy, utilities and health care.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 8, 2023, “Sell the News or Buy the Pause?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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