Are Investors Overlooking This Key Factor?

In both the U.S. bond and stock markets, an air of optimism seems to surround the Federal Reserve’s decision to tighten monetary policy:

• Bond investors have sent shorter-term Treasury yields surging, while keeping future inflation expectations relatively low. Market measures suggest inflation will average around 2.85% in five years and 2.45% in 10—far from today’s 7.5%. This implies the Fed will quickly succeed in fighting inflation as it raises interest rates, even if the move risks a slowdown in economic growth or a recession.

• Stock investors seem to believe that corporate profitability will remain high, even if the Fed’s tightening results in lower demand and slower economic growth in line with falling inflation. This assumes companies have the pricing power to outrun any input-cost increases and preserve earnings-growth momentum.

We disagree with these oversimplified views and think the Fed’s policy tightening will be more complicated than what markets currently anticipate. In fact, the planned interest-rate hikes are only part of the story. Here’s why:

• First, inflation isn’t just about supply chains. We remain skeptical of the argument that the current inflation situation is all about supply-chain-related price pressures and thus will rapidly cure. Ellen Zentner, Morgan Stanley’s chief U.S. economist, recently noted that the higher-than-expected January consumer price index reading was not driven by supply-chain-dependent goods, but rather by prices for core services such as rents and medical care. These are areas that are poised to continue to recover and see inflationary pressures likely persist.

• Second, inflation this time isn’t about credit excesses. In expecting the Fed to quickly tame inflation, the market assumes that higher short-term rates will be effective in cooling demand and, thus, inflation. That may have worked if credit growth were fueling higher prices, like in prior episodes of demand-driven inflation, but that’s not the case today. We believe inflation has been supported by a host of structural factors such as demographic change and deglobalization, as well as excess liquidity. For example, cash-to-liabilities ratios for U.S. households, corporations and the banking system are all at their best levels in over 30 years, according to independent researcher Gavekal. This suggests rate hikes alone are unlikely to dampen cashflow-driven demand.

So what is the market missing? We think investors may be too focused on rate hikes at the risk of overlooking the impact of excess liquidity and the Fed’s eventual withdrawal of it. Recall that over the past two years, global central banks have injected well over $10 trillion in liquidity. Tackling inflation means tackling this excess. 

We anticipate that in the next 12 months, central banks will drain $2 trillion of global liquidity, with the Fed accounting for about half as it reduces the size of its balance sheet in a process dubbed quantitative tightening. Draining excess liquidity alongside interest rate hikes poses genuine headwinds to rich stock valuations, but it also creates a longer runway for securities that are fairly priced. We encourage investors to consider actively exploiting market volatility for quality growth stocks that are reasonably priced, taking a broadly diversified approach that includes non-U.S. exposure. Global financials, in particular, appear an effective hedge against rising rates and a steeper yield curve.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Feb 14, 2022, “Great Expectations?”  Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.