Morgan Stanley
  • Wealth Management
  • Mar 1, 2021

Rising Rates May Signal Significant Market Shifts Ahead

Some investors may be tempted to buy amid the moderate dips in stock prices, but we lay out the rationale for a more nuanced approach.

The second half of February brought not just a market selloff, but also indications of a more serious potential shift in market outlook. Just two weeks after hitting a high of 3948 on Feb 16, the S&P 500, the benchmark index of the broader U.S. market, has fallen 3.5%, while the tech-and-growth-stock-heavy Nasdaq index is down about 6.4%. For some, that may seem like the kind of moderate dip that could be a buying opportunity, but we don’t believe that’s the case right now.

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A close look at interest-rate dynamics suggests that fundamental market conditions may be changing. In the past two weeks, we’ve seen the benchmark 10-year Treasury yield surge as high as 1.6% from 1.3%—compared with its historic low of 0.5% last August. The recent surge may indicate a reassessment of the speed of the U.S. economic recovery and the likely Federal Reserve policy response.

Investors finally be taking note of the economy’s faster-than-expected growth. Our own outlook for GDP growth has topped the consensus forecast since last spring and continues to move up, with the most recent estimate for fourth-quarter 2020 annualized growth of 6.7%. If the economy returns to its pre-pandemic growth trend well ahead of Fed forecasts, the timetable for interest-rate hikes could accelerate.

New Market Realities

Investor faith that interest rates would remain stable at very low levels has helped support sky-high price-to-earnings multiples this year. Growth stocks are often valued against the yield on a low-risk Treasury bond—the wider the spread, the larger premium that an investor is expected to pay for the added risk of growth. As rates move higher, stock prices often adjust to reflect that narrowing gap. That may be a big reason why tech stocks, in particular, got hit so hard last week. 

These market realities may lead to a shift in Fed rhetoric. While Fed Chair Jerome Powell seems steadfast right now in his belief that any gain in inflation is likely temporary, we’re not so sure. A number of dynamic factors, such as money-supply growth, higher wages and increased fiscal stimulus, against a backdrop of pent-up demand for consumer services, could lead to inflation levels that require a Fed response.

Investors may be hedging their expectations, as more of them wonder when the Fed will pivot from its ultra-dovish policy stance. Already, analysis of fed funds futures and overnight index swap markets suggest that investors now expect the first Fed rate hike could come in February 2023, well ahead of the Fed’s current guidance of December 2023, and seven months earlier than what these markets indicated as recently as Feb 10. 

Potential Fed Policy Shifts

Also, survey-based indicators from primary dealers and investors suggest that market participants believe that a tapering of the Fed’s bond-buying program will begin in the first quarter of 2022. For that timeline, the Fed would have to start signaling a shift later this year to avoid major market upset, similar to what we saw with the 2018 “taper tantrum.”

This shift in policy expectations has material implications for portfolio construction, suggesting not only shifts in sector and regional positioning, but fresh approaches to diversification, as rising rates produce potential headwinds for both stocks and bonds simultaneously.

Investors should consider adding economically cyclical sectors that can take advantage of global reflation. We also suggest maintaining positions in defensive sectors that would likely do well if the faster-growth, rising-rate scenario takes longer to materialize than indicators now suggest.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 1, 2021, “Rates and the Rotation.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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