Deciphering bond market signals

Morgan Stanley Wealth Management

10/20/22

Summary: Recent action may indicate the bond market is coming to grips with the reality of higher interest rates and long-term inflation. What could it mean for investors?

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Could September’s disappointing inflation report mark a turning point for markets?

The latest consumer price index (CPI) data came in higher than Wall Street forecasts, with the overall index up by 0.4% for the month and 8.2% higher than a year earlier. The “core” figure, which strips out the more volatile food and energy prices, climbed 0.6% for the month and is up 6.6% for the year, the biggest year-over-year increase since 1982. This follows year-over-year rises in core prices of 6.3% in August and 5.9% in July.1

For the last few months, Morgan Stanley’s Global Investment Committee has consistently flagged the potential staying power of inflation, particularly due to the “stickiness” of higher wages and housing costs, as well as a resurgence in demand for services such as airfares and health care.

Yet many investors have been slow to embrace the reality of persistent inflation and the Federal Reserve’s resolve to fight it with aggressive monetary tightening, instead hoping for policymakers to ease off on rate hikes and for inflation to quickly subside.

But the latest CPI report appears to have dented those hopes, based on the aggressive response across fixed-income markets immediately following its release:

  • Treasury yields surged to multi-year highs—sending bond prices tumbling—with the key 2-year yield approaching 4.5% and the 10-year topping 4%.
  • Market expectations rose for this cycle’s terminal rate, or the point at which the Fed will stop raising rates, to nearly 5.0%. Currently, the Federal funds rate is in a target range of 3%–3.25%.

These moves suggest the bond market is pricing in a “new normal” of higher interest rates and longer-run inflation.

What are the investment implications?

At current prices, short-duration Treasuries look attractive as they offer yields that are more than 2.5 times the dividend yield on the S&P 500 Index1 thus providing investors with reliable income over the next year, when economic growth may slow.

As for stocks, however, the immediate path ahead is not as straightforward. Prices still need to adjust to reflect a more realistic earnings outlook. Morgan Stanley’s Global Investment Committee believes the strong demand and pricing power that companies have enjoyed in recent years, and the resulting record operating margins, are simply not sustainable. If earnings growth were to return to its long-run average, even without an economic recession, we could be seeing a 10%-15% decline from current estimates for 2023 earnings.1 Although some sectors have factored this in, mega-cap secular growth stocks are likely to still hold risk.

As the third-quarter earnings season begins, investors should pay attention to companies’ guidance for 2023, particularly to see if there’s an acknowledgement of the potential for a “profit recession” or negative year-over-year change in profit growth. Meanwhile, consider locking in solid yields in short-duration bonds and exploring dividend-paying stocks as we wait out equity-market volatility.

The source of this Morgan Stanley article, How Can Investors Prepare for the Bond Markets’ New Normal?, was originally published on October 18, 2022.

  1. Morgan Stanley Wealth Management Global Investment Committee, "Bear Market Act II,” October 18, 2022

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.  Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, and sale, exercise of rights or performance of obligations under any securities/instruments transaction.

The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.

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