Morgan Stanley
  • Wealth Management
  • Jul 19, 2022

The Critical Data Some Investors Are Ignoring

Equity investors may be missing these important signs of a coming profits recession. Learn the moves to make now.

Coming into the third quarter, some market-watchers believed inflation was peaking. In turn, interest rates slipped from their recent peak and investors thought the Federal Reserve might reverse its aggressive monetary tightening. Traders priced in interest-rate cuts in 2023, and equities rebounded amid a relatively positive mood. 

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That changed last week. The latest price report showed still-scorching inflation, with consumer prices rising 9.1% year-over-year in June. The numbers spurred volatility in both bond and currency markets and renewed concern about even more aggressive rate hikes and recession. To illustrate:

  • The 2-year/10-year Treasury yield curve inversion deepened, and the 3-month/10-year curve, which some market observers and Fed policymakers consider a more useful indicator, is flattening.
  • The U.S. dollar hit a fresh 20-year high against other major currencies.
  • Futures now indicate potential rate cuts of up to 90 basis points by 2025, suggesting the U.S. economy may struggle to cope with rising rates and that the Fed may eventually be forced to cut them again. 

But stock investors seem to have missed the memo. Against the same backdrop, equities have stayed relatively stable, continuing to churn within their 3-month range and their volatility index remaining just above its 5-year average. What’s more, corporate earnings expectations are still robust, pegged at a 10% year-over-year growth rate.

Why the disconnect? U.S. equity investors seem to be complacently relying on the idea that, with sticker prices remaining high, businesses will be able to pass on their rising costs to consumers to shelter margins.

Such a scenario seems unlikely. Historically, notable corporate profit declines accompany inflation at these levels. For example, between March 1980 and June 1982, when inflation fell from nearly 15% to around 7% amid drastic Fed rate hikes, profits contracted by 23%, and the S&P 500 Index suffered through a bear market with a peak-to-trough drawdown of nearly 40%.

In the current environment, companies’ pricing power may not be enough to offset or outpace cost increases, particularly given that wholesale prices are growing faster than consumer prices. The producer price index, a proxy for corporate costs, surged a staggering 11.3% from a year ago in June, outpacing consumer prices by more than 2 percentage points—not a recipe for sustained profit margins.

Add to this the potential that continued high prices could start to erode consumption. And with inflation helping keep the U.S. dollar strong, profits for multinational companies may face headwinds, while overall U.S. competitiveness globally could weaken.

Ultimately, given the dynamics of the V-shaped recovery, a profits recession—or negative year-over-year change in profit growth—seems unavoidable. While strong capital investment and solid productivity gains may lie on the other side of the current situation, we are not there yet.

Investors should stay vigilant and defensive. Watch corporate earnings results and forward guidance, and look to deploy excess cash into Treasuries, municipal bonds and investment-grade bonds, along with international equities.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 18, 2022, “Living in a Nominal World.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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