3 Signals of Equity Market Trouble

Feb 22, 2023

Will economic growth today simply postpone a “hard landing”?

Lisa Shalett

Key Takeaways

  • Some investors believe economic growth can remain robust or even re-accelerate.
  • However, resurgent growth would likely spur the Federal Reserve to keep interest rates higher for longer.
  • Higher interest rates would pressure stock valuations, making defensive stocks a potentially prudent choice.

Wall Street has speculated for months about whether the Federal Reserve’s aggressive efforts to tame inflation would drive the U.S. economy into a hard landing or a soft one. Investors are now floating a new theory: “no landing.” It’s the latest iteration of a bullish narrative underlying the stock market’s notable recovery from last year’ lows.


The thinking goes something like this: Instead of an outright recession or a gentle economic slowdown, growth can remain robust—or even re-accelerate—and companies can achieve their earnings estimates. Proponents of this view cite recent data showing continued momentum in consumer spending and a strong labor market.


As regular readers may know, Morgan Stanley’s Global Investment Committee is skeptical of this perspective. Economic resilience doesn’t occur in a vacuum; it usually comes with resilient inflation. That may lead to a stronger policy response from the Fed and higher interest rates, which could ultimately curb further economic growth and weigh on asset prices—a possibility equity investors seem to be shrugging off.


Consider the following three developments that indicate there’s more risk than recent stock gains may imply: 

  1. 1
    Asset classes other than equities are factoring in strong economic data and preparing for higher rates.

    Bond yields have moved up significantly, with the 10-year Treasury yield hitting 3.8%, and the policy-sensitive 2-year yield reaching 4.6%, its highest since November. What’s more, over the past two weeks, the U.S. dollar has strengthened 3%, while West Texas crude oil prices rose about $3 per barrel. These moves suggest that equity investors are ignoring fundamental data that is having an impact on other assets, and may be caught off guard when higher rates eventually weigh on stock valuations.

  2. 2
    Market-based inflation expectations have moved up.

    The 2-year breakeven rate—reflecting the market’s estimate of inflation in the next two years—has risen to 2.9%, well above the Fed’s inflation target of 2%. Perhaps more importantly, traders have amped up their expectations for the terminal rate, or how high the Fed will take the Fed Funds rate this hiking cycle, to beyond 5%, up from early February’s market-based forecasts of around 4.75%. 

  3. 3
    Consumer and producer prices are no longer declining with speed.

    Recent consumer prices data showed month-over-month gains of 0.5%, the largest move in three months. Compared with a year earlier, inflation has slowed to 6.4% but missed expectations for 6.2%. The wholesale side substantiates the trend, with producer prices rising 0.7% in January, also stronger than expected. 

These three factors have yet to change the bullish mood in stocks. Any recent attempts at market repricing have been met with investors attempting to “buy the dip,” therefore driving stock prices back up. Continued resilience in consumption tends to mean persistent price pressures. This, in turn, means policymakers are likely to keep interest rates higher for longer, ultimately pressuring stock valuations. In a sense, the “no landing” theory may simply be a “hard landing” that is being postponed.


Investors should consider opportunistically adding defensive stocks that have recently sold off, with a focus on dividend and cash-flow yields, as well as earnings achievability.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from February 21, 2023, “Don’t Bet on ‘No Landing.’” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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