Will investor optimism hit a Fed wall?

Two key takeaways:

• Anticipated economic growth, cooling wages, and tightening financial conditions could be viewed as signs the Fed may lower interest rates.
• However, the Fed may continue to see good reasons for keeping rates high so they can prevent sticky inflation.

Morgan Stanley’s Global Investment Committee (GIC) believes the Fed’s progress in taming inflation has stalled out and that Fed officials know it. There have now been three straight months of inflation rate increases since June’s 3% annual rise in the consumer prices index (CPI).

Amid persistent inflation, the GIC believes there is a growing likelihood the central bank will keep a tight grip on monetary policy to choke off growth and create slack in a still-tight labor market. This suggests a soft economic landing may not be assured.

The Fed has clearly signaled that it is still focused on slowing down growth. While some investors may remain optimistic, betting against the Fed is rarely a long-term winning strategy. Instead, the GIC expects the market to trade sideways for a while as US growth and labor dynamics continue to drive Fed policy.

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

• Stay defensively and cautiously positioned and balance equity exposure in their portfolios between offensive and defensive stocks, with a particular focus on quality.
• Move toward medium-term bonds, where historically high yields may be found.

Some investors may be using losses on municipal bonds, preferred securities, or Treasuries to help offset capital gains elsewhere in portfolios for tax purposes, a process known as tax-loss harvesting.

1. The economic growth forecast

Some bullish stock investors foresee a “soft landing” scenario that features 12% compound annual growth in corporate profits through 2025 alongside falling inflation and reaccelerating “real,” or inflation-adjusted, economic growth. However, the GIC says that scenario seems highly unlikely. Relatively loose monetary policy could fuel economic growth, but it would also leave room for inflation to stay elevated. On the flip side, corporate cost-cutting could support profitability but would likely lead to lower economic growth, higher unemployment, and a weaker consumer. Either way, expectations for such an optimistic scenario stand in contrast with the Fed’s current focus.

2. Cooling wages

Some investors point to slowing hourly earnings growth as a potential cue for the Fed to ease its grip on monetary policy. However, the GIC believes the Fed sees a job market that is still hot, especially given last month’s surprisingly strong job openings numbers and payrolls. Prime-age labor participation has already surpassed pre-pandemic levels. In addition, initial weekly unemployment claims are still averaging what the GIC calls “an exceptionally low” 225,000 per week, half the five-year average. Their conclusion: If the Fed wants to tackle inflation by reducing wage pressure, it still has work to do.

3. Global financial conditions

Financial conditions have started to tighten. Some bullish equity investors may view resurgent oil prices, a strong US dollar, and the recent run-up in long-term Treasury yields as potential reasons for Fed hawks to back off on rates. However, the GIC contends that Fed rate cuts could still be many months away, noting that the Fed typically waits for market variables to finish tightening before it considers cuts.

Some bullish investors appear to believe the Fed will lower interest rates based on anticipated economic growth, cooling wages, and tightening financial conditions, but the GIC contends that the Fed is still focused on taming inflation and thus could keep rates higher for longer.

Investors whose views align more closely with the GIC’s may be balancing equity exposure between offensive and defensive stocks and moving toward medium-term bonds.

The source of this article, Will Investor Optimism Hit a Fed Wall, was originally published on October 18, 2023.