Have investors stopped ‘fighting the Fed’? What higher rates could mean for your portfolio

• The Fed’s latest forecasts threw cold water on investors’ hopes for a full percentage point of interest-rate cuts in 2024.
• Some investors are favoring active stock selection over passive index investing and balancing portfolios between offensive and defensive stocks.
• Equity markets were rattled by the prospect of higher-for-longer rates and may tread water for the next few quarters.

Markets may have finally gotten the message that the Fed is planning to keep rates higher for longer.

Since 2021, the Fed has cautioned investors that inflation could prove sticky and that the central bank will steadfastly keep interest rates higher as needed to bring inflation to a heel. However, many investors didn’t heed this message, believing instead that monetary policy would quickly ease and US stocks would continue moving higher.

Stocks’ extended selloff following September’s Federal Open Market Committee (FOMC) meeting may indicate that the Fed’s message is now loud and clear. The S&P 500 and Nasdaq indices ended the week of Sept. 18 down 2.9% and 3.6%, respectively, with both on pace for consecutive monthly declines for the first time in a year. Government bond yields, meanwhile, surged to their highest levels in more than a decade, as investors reassessed the likelihood of higher-for-longer rates.

Here’s what higher for longer rates may mean for your portfolio.

When all else is equal, lower interest rates increase the value of a company’s future earnings and therefore should boost stock valuations.

But now, Morgan Stanley’s Global Investment Committee (GIC) believes some investors may have to adjust to higher rates, which could make equities less attractive compared to safer fixed-income investments. This environment may favor active stock selection over passive index-level investing in some cases.

According to the GIC—and keeping in mind that individual investors’ circumstances will vary based on their goals and risk tolerance—some investors may:

• Balance equity exposure in a portfolio between offensive and defensive stocks.
• Diversify portfolios given that broad US stock indices are likely to trade in a static range for the next few quarters.

Also, the fourth quarter may be a good time to consider using any losses on municipal bonds, preferred securities, or Treasuries to help offset capital gains elsewhere in your portfolio for tax purposes, a process known as tax-loss harvesting.

What prompted markets to react so strongly following the September FOMC meeting? At first glance, the central bank did exactly what markets had predicted: It held interest rates steady. But Fed Chairman Jerome Powell’s press conference and the “dot plot,” which illustrates officials’ rates projections, offered a few perspectives that differ from investors’ previous assumptions.

For one, policymakers suggested at least one more rate hike is likely, and that 2024 would bring probably no more than half a percentage point worth of cuts—a disappointment to markets whose consensus view just the prior week was for one whole percentage point of cuts next year.

In addition, the central bank underscored that:

• While inflation has thus far come down faster than expected, core inflation around 4% is still far from the Fed’s target, and a strong labor market makes further inflation progress uncertain.
• GDP growth for 2023, previously forecast at about 1%, is now expected to be more than twice that. Further, 2024 growth is estimated at 1.5%, higher than previously predicted. With growth stronger than anticipated, pressure remains for rates to stay higher.

Sticky inflation may keep interest rates aloft.

The GIC believes some investors may balance equity exposure and diversify portfolios heading into 2024, as economic growth is set to be higher than expected.

The source of this article, Have Markets Finally Adapted to Higher Rates?, was originally published on September 27, 2023.