Optimistic investors are sending U.S. stocks higher, but they should be wary of moves that “fight the Fed.”
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An old saying, “Don’t fight the Fed,” cautions against investing in ways that might run counter to U.S. central bank policy.
Yet many investors today seem emboldened to wage this fight. Although the Federal Reserve has offered explicit guidance that continued monetary tightening may be needed to subdue inflation, investors seem to have ignored how such policy action could further weigh on the economy and corporate profits. Instead, they have sent U.S. stocks rallying on the apparent conviction that inflation will quickly fall to the Fed’s target of 2% and that the central bank will soon turn to cutting interest rates.
The rebound has sent valuations to extreme levels again, with the S&P 500 Index now priced at 18.5 times forward earnings.
But is this confidence warranted? Is inflation truly tamed, and will the U.S. economy come out of this tightening cycle with just a scratch?
We’re not so sure. Morgan Stanley’s Global Investment Committee believes investors should recognize that this is a period of profound uncertainty. Three developments are amplifying our concern:
- The economic outlook is blurry. Consumers are spending down their savings and running up credit card balances at a time when corporate layoffs have begun in some sectors. Even as service sectors remain strong, manufacturing new-order rates continue to decline, suggesting weaker demand for goods. Some investors expect the economic recovery in China to rescue the U.S. economy from steeper decline, but if U.S. growth rebounds, that could put upward pressure back on prices and prompt the Fed to keep rates higher for longer, in turn weighing on asset prices.
- Corporate profits remain vulnerable. The consensus estimate for S&P 500 company earnings this year is higher than likely at $224 per share. This relatively sanguine forecast is based on 2020-2022 trends, which seems to ignore the fact that economic growth has been extremely distorted in those recent years: For the past 10 quarters, U.S. nominal GDP has run between 9% and 14%, versus the long-run trend of 4-5%, and S&P 500 operating margins have averaged 14.5-16.5%, versus the 25-year average of 12.5%. The tendency for performance to revert to a long-term average could bring about a negative year-over-year change in earnings growth, known as a “profits recession.”
- Strength in the labor market persists. Despite gathering headlines on layoffs, the U.S. labor market has remained strong overall, as measured by large numbers of new job openings and a recent 53-year low in the unemployment rate. A resilient jobs market could help the economy achieve a “soft landing” if robust real wages support consumption. The conundrum, however, is that strong wages and spending would likely add to inflationary pressures and thus provide little rationale or incentive for the Fed to cut rates.
Granted, inflation has likely peaked and the bulk of Fed tightening is probably behind us. But remember that policy operates with a lag, and uncertainty around the economy, earnings and jobs matters. It is a confusing time that demands hedging one’s portfolio positioning. To that end, investors should focus on income generation while this cyclical period of maximum uncertainty plays out. Lean into short- to intermediate-term Treasuries, municipals, investment-grade corporate bonds and dividend-growth stocks.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from February 13, 2023, “Entering the Fog Zone.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.