How Investors Can Prep for More Volatility

May 2, 2023

Rising risks of “stagflation” and questions around U.S. debt could lead to renewed market turbulence. What to do now.

Lisa Shalett

Key Takeaways

  • The adage “sell in May and go away”—reflecting historically weaker May­-to-October stock performance—may prove apt this year.
  • Slowing growth, persistent inflation, deteriorating corporate earnings and new government borrowing all threaten to destabilize markets.
  • Investors should consider defensive stocks in sectors such as consumer staples, energy, utilities and healthcare.

A popular stock-market maxim, “Sell in May and go away,” illustrates the seasonality of stock market gains in the first several months of the year and the historically weaker performance of equities from May to October.


This adage may be especially apt this year, given mounting risks to the U.S. economy and markets. Bullish investors continue to hope for an economic “soft landing” and eventual interest rate cuts by the Federal Reserve that would justify today’s high equity valuations. However, bearish investors cite data indicating that the odds of a recession are rising and that there are threats to market liquidity. Both could lead to renewed market turbulence.


Last week, new evidence suggested that the bearish scenario is more likely over the next three to six months:


  • Slowing growth and persistent inflation: Economic growth is losing momentum faster than hoped, while progress on inflation is stalling—raising the specter of “stagflation.” Last week’s Bureau of Economic Analysis report showed that U.S. gross domestic product (GDP) rose at an inflation-adjusted 1.1% in the first quarter of 2023, missing economists’ 1.9% forecast and marking a significant slowdown from 2.6% in the fourth quarter of 2022. At the same time, the core personal-consumption expenditures (PCE) index, the Fed’s preferred inflation gauge, remains stubbornly high at 4.9%, up from 4.4% in the previous quarter. These developments add pressure on the Fed to keep rates higher for longer and further complicate its job of taming inflation while minimizing damage to the economy. 
  • Deteriorating corporate earnings: While investors may think first-quarter earnings so far have not been as bad as previously feared, a deeper look should raise concern. At this point in the reporting season, earnings are down about 5% year-over-year, with results suggesting pressures on profit margins. More importantly, the quality of earnings looks to be weakening, with the gap between companies’ actual cash and earnings on paper at its largest since 2008. Share buybacks also may be boosting earnings-per-share numbers, since buybacks reduce the number of shares outstanding. However, such financial engineering looks increasingly dubious, as rising costs of capital weigh on corporate bottom lines. 
  • Unsustainable national debt dynamics: If Congress agrees to lift the federal debt ceiling in the months ahead, as we expect, a new wave of government borrowing could drain hundreds of billions of dollars from the financial system in just the second half of this year. Additionally, the International Monetary Fund forecasts that the U.S. could see as much as $2 trillion in additional Treasury issuance per year through 2030, in the absence of a plan to control the swelling national debt. The likely result: higher-for-longer rates that would weigh heavily on bonds and stocks alike over the intermediate term.


As a result, investors should pay attention to 10-year real Treasury rates as the ultimate arbiter of economic growth, inflation and the long-term cost of capital.


In the meantime, while we await further indications of where the economy is ultimately headed, we believe:


  • Equity investors should look to traditional “defensive” sectors, such as consumer staples, energy, utilities and healthcare, over consumer tech and discretionary, which have strong and often underestimated links to the overall health of the economy.
  • Investors considering bonds as a stock hedge should be wary of long-duration notes. Mammoth supply of long-duration bonds is likely coming, which suggests long rates will not fall as much as equity investors are anticipating.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 1, 2023, “Mayday!” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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