What worked for investors in the past may not be profitable heading into 2023.
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Most of us are subject to what researchers call “cognitive inertia,” the tendency to cling to existing beliefs even as circumstances change. For investors, this could prove perilous if they’re not vigilant about material changes in the economy and markets.
During the prior market cycle, from March 2009 to February 2020, an environment of low and stable inflation, soft economic growth and an accommodative Federal Reserve formed investor assumptions and behavior. We saw historically high returns, with U.S. stocks rising more than fivefold and 10-year Treasury yields falling from about 3% to 0.55%.
Back then, the relative winners were clear:
- passively tracked indices over actively selected securities,
- growth stocks over value stocks,
- defensive sectors over cyclicals, and
- U.S. investments over non-U.S. investments.
That all began to change at the end of 2021, when the Fed, amid a rapid rebound from the 2020 pandemic-induced recession, acknowledged that higher inflation could persist and embarked on one of the most aggressively paced rate-hiking programs in about 40 years. With the Fed Funds Rate rising 4.5 percentage points in just the past nine months, markets have responded by driving up Treasury yields, which in turn has reduced stock valuations somewhat. Still, investors in parts of the market, such as Fed Funds futures, have been slow to fully embrace the Fed’s now relatively hawkish guidance, clinging instead to more dovish forecasts that could support higher equity valuations.
What Comes Next?
But a new investment environment could soon take shape, possibly quite rapidly, and investors shouldn’t be complacent. They should think about how the new cycle is likely to shape up, and what that could mean for their portfolios. Consider two potential scenarios:
- More of the same: Some investors think interest-rate cuts are coming in the near term and with them, a return to prior market-cycle dynamics. In this scenario, companies somehow manage to grow profits even with the rising probability of recession. U.S. growth stocks, commonly owned through vehicles that passively track indices like the S&P 500, are again clear market leaders, as inflation fades and low interest rates support rich equity valuation multiples.
- Stronger growth, higher rates: In the more likely scenario, markets do not go back to the old environment but instead start a fresh one marked by stronger economic growth. Decarbonization and deglobalization, among other factors, create incentives for increased capital investment. Inflation normalizes closer to 3%, and rates remain higher for longer. In the markets, fundamentals such as a company's revenues, earnings and return on equity take on added importance. Value stocks come into favor over growth stocks, cyclicals lead defensives, and international stocks outperform U.S. indices.
Of course, it is understandable that after a decade of success using one strategy, investors continue to hope for the same. And knowing when to toggle and rebalance your portfolio is not easy and requires a deliberate and data-driven process. But with a new cycle dawning, investors should consider repositioning portfolios toward fixed income, value, dividends, enterprise technology and emerging market stocks.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from December 19, 2022, “Recognizing Regime Change.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
