Is an Economic Soft Landing Still Possible?

The Federal Reserve raised interest rates last week by 75 basis points, the biggest single increase since 1994—and signaled more big hikes to come—in its continued effort to tame the highest inflation the U.S. has seen in 42 years.

But the Fed may have created more questions than answers, especially since it said previously that a rate hike of that size was “off the table.” While markets initially cheered the Fed’s announcement, recession risks are actually rising and market valuations are under more pressure:

• The likelihood of a recession on most econometric models has now risen from 30% to about 60%. The Fed suggested there could be continued acceleration in policy-tightening, raising forecasts that the fed funds rate could rise to over 3% by year’s end and top out at 3.8%, well ahead of most economists’—and the Fed’s own—previous forecasts. Such aggressive positioning to slow the economy means greater risk of actually tipping it into a recession.

• Stocks now face further downside risk. It’s notable that even as consumers’ inflation expectations have risen significantly, the market’s gauge of inflation expectations, known as “breakeven” rates, appears rather stable. This means that the rise in nominal interest rates—inflation premiums plus inflation-adjusted “real” rates—has been accounted for almost entirely by real rates. That’s concerning because soaring real rates could continue to pressure equity valuation multiples, just as earnings forecasts are being reduced by recession fears.

Further complicating the Fed’s efforts is emerging evidence that inflation may be peaking and the economy cooling on its own. Yes, inflation is still high and May’s consumer price index level was disappointing, but recent producer price index data were better than expected on almost every score. In addition, price gains for goods are starting to decelerate as supply chains clear, inventories rebuild and demand cools, as evidenced by weaker retail sales. Housing-related demand is also slowing. And, perhaps most compellingly, the Atlanta Fed is currently forecasting 0% quarter-over-quarter GDP growth for the second quarter.

This all raises the question: Is a true economic “soft landing” still possible? We think so but worry the possibility may now be slim. Inflation this cycle seems to be driven by things the Fed can’t control, such as geopolitics. What’s more, the Fed's efforts to tighten financial conditions through rate hikes and balance-sheet reduction may not be the cure needed for today's inflation, given that it was extreme levels of fiscal stimulus providing liquidity to households and markets—not excessive borrowing—that likely drove excess demand in the first place.

As we continue to weigh bull-and bear-case scenarios for the economy and markets, investors should watch financial conditions in the U.S. and beyond, as global central banks also begin tightening their monetary policies. Portfolio strategies to consider now include maximum diversification, quality factors and active management. Deploy fresh cash toward investment grade bonds, international stock funds and select cyclical areas. We’re focused on small-and mid-cap stocks, especially in biotech, financials, energy and industrials.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 21, 2022, “Fed Up.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.