Making Sense of Tumultuous Markets

Stock market volatility was on full display last week. Investors drove equities sharply higher last Wednesday, with the S&P 500 Index gaining 2.99%, after the Federal Reserve announced a widely expected half-percentage-point hike in interest rates and dismissed the idea of a 0.75 percentage point hike in the future. Just the next day, however, U.S. stocks nosedived, with the S&P 500 extending its losses Friday to end the week down 0.2%.

Some broader context: Heading into last week, April’s losses had made valuations of even the most coveted mega-cap tech stocks more attractive, and technical indicators were also suggesting “oversold” market conditions. So, it isn’t altogether surprising that stocks staged a brief, midweek “relief rally,” as investors appeared to reflexively “buy the dip” once again. However, as we saw the rest of the week, markets remain volatile. We advise taking caution ahead, seeing at least three areas of uncertainty that may continue to weigh on markets: 

• The move toward tighter U.S. monetary policy is accelerating. Rate hikes are just getting started, with a doubling in magnitude for the first two. What’s more, the Fed is now set to start shrinking its balance sheet by as much as $47.5 billion a month in June before ramping up to $95 billion a month after three months. Financial conditions have tightened, and current market expectations show that rates are likely to rise by another 2 percentage points by year-end. As Fed Chair Jerome Powell acknowledged last week, a “soft landing” for the economy is not guaranteed. In fact, 11 of the 14 Fed tightening cycles since 1950 have resulted in recession.

• The corporate profit outlook is dimming. While first-quarter earnings were generally better than expected, these results are backward-looking and don’t reflect the full impact of tightening policy and slowing growth. Earnings expectations need to be recalibrated, as corporate profits face a number of headwinds, including:
• margin pressure from rising costs,
• a normalization of demand from the early days of the pandemic,
• weaker international demand and
• the strongest dollar in decades, which can hurt U.S. exports and the translation of overseas profits by U.S companies.

Likely reflecting these challenges, a growing share of companies are now lowering their expectations for future performance.

• Geopolitical uncertainty remains high, and events outside the U.S. continue to affect trade, supply chains and commodities. With no resolution to the Russia-Ukraine conflict in sight, for example, Europe is now poised to ratchet up energy-related sanctions that may sustain inflationary pressures for the foreseeable future. This creates uncertainty for central banks, feeds volatility in currencies, produces headwinds to COVID recoveries, and raises the pressure on emerging market countries already laboring under high costs.

With uncertainty high, investors should practice discipline, even as “buying the dip” may seem attractive, and demand compensation for risk in the next six months or so. Remain patient until there is some clarity around inflation, monetary policy, earnings and international events, as well as more cover from compelling risk premiums. Consider taking profits in passive indices and redeploying toward active managers, and look to Treasuries, which we think are trading closer to fair value.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 9, 2022, “Muscle Memory.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.