There’s More to This Market Than the Fed’s Next Move

For most of 2022, investors have seemed to have a single-minded obsession with the direction of Federal Reserve policy. Given the level of inflation we’ve seen, and the outsized role that monetary policy has played in driving market outcomes since 2008, this focus is understandable.

But there’s more to consider in the current market than the Fed and its fight against inflation. And we worry that a myopic, domestic focus may ignore other important dynamics that could have an impact on investment portfolios. 

First, we continue to see risk in today’s corporate earnings forecasts. They still appear unrealistically high, especially given the recent re-affirmation from Fed Chair Jerome Powell of the central bank’s commitment to fighting inflation, even if it means inflicting some pain on the economy and corporate profits. 

Consensus earnings expectations have come down a bit, but estimates for 2023 are still up 5% over 2022, and Morgan Stanley expects another leg down, of about 10%-15%. We think corporate executives and Wall Street analysts may be underestimating the potential loss of pricing power that companies will experience with further rate cuts and falling inflation, as inflation has helped keep higher nominal prices. In addition, complex cross-currents coming from consumers’ shift from goods to services could have an impact on some sectors that have thrived during the pandemic, including retail, consumer goods and automotive. Finally, of course, the broad economic slowdown will have widespread effects.

Also concerning is the U.S. stock market’s apparent dismissal of global dynamics. Certainly, the market has recognized the risks of the Russia/Ukraine war and the obvious implications to global energy and food prices. But with oil prices having pulled back and inflation largely seen as having topped out, we are concerned about U.S. investor complacency around global risks and opportunities having little to do with the Fed.

• First, the situation in Europe bears watching. The energy crisis is getting worse, with natural gas and electricity prices soaring. This has pushed eurozone inflation rates above 9% and raised the probability of a severe recession. The European Central Bank will likely need to begin its own cycle of rate hikes just as the economy heads in a slowdown. Incremental pressure to help destroy demand there may ultimately fall back on the Fed—a risk that does not seem priced by financial markets. While uncertainties remain around inflation and policymaking, markets do seem to have factored in a potential recession in Europe, reflected in the euro’s weakness against the U.S. dollar and 12-year-low equity valuations relative to U.S. stocks. This could mean potential opportunities for patient, value-oriented investors.

• Next, in China, the economic situation may actually be the reverse of Europe’s. While negative headlines about lingering COVID shutdowns may persist, the upcoming Communist Party Congress and the vote to elect Xi Jinping as its leader for a historic third term could set the stage for what’s likely to be a string of economic stimulus programs. Chinese securities’ performance could also benefit from a potential resolution with the SEC of issues around shares of Chinese companies held by U.S. depositary banks. And, unlike other major markets, China has low inflation, high real interest rates and a relatively strong currency, which give the country plenty of policy flexibility.

• One final note for investors is the potentially destabilizing effect of an excessively strong U.S. dollar. While dollar strength has tempered U.S. consumer inflation, it’s also increasingly a headwind for S&P 500 company earnings and the competitiveness of American multinationals. U.S. financial assets are looking increasingly unattractive for foreign investors.

The bottom line is that investors cannot remain myopically focused on just the Fed. There are other dynamics and risks in play, and global portfolios may need to be rebalanced. Investors should maintain global diversification, resisting the temptation to exit near the lows. In the near term, valuations for stocks outside of the U.S. are much more compelling than those for domestic equities. And in 2023, non-U.S. markets will likely present more potential for upside surprises.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 6, 2022, “Global Complications.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.