Morgan Stanley
  • Wealth Management
  • October 31, 2022

How Can Investors Prepare for the Bond Markets’ New Normal?

Bond investors may be coming to grips with the reality of higher interest rates and long-term inflation. What could it mean for markets?

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

Last week’s 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. 

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.

By contrast, 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. For months, they have instead undercut Fed guidance, hoping for policymakers to ease off on rate hikes and for inflation to quickly revert to the sub-2% levels last seen during the extended period of slow economic growth, or “secular stagnation,” for the U.S. prior to the pandemic. 

But the latest CPI report finally appears to have dented such hopes, based on the aggressive response across fixed-income markets last week:

  • Treasury yields surged to multi-year highs, 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%.
  • The Fed Funds rate is now estimated to reach 4.5% by January 2024, a full percentage point above our forecast for core CPI—a stark potential reversal from recent dynamics in which the interest rate has remained well below core inflation.

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

What are the investment implications? At current prices, short-duration Treasuries are looking attractive, as they offer yields that are more than 2.5 times the dividend yield on the S&P 500 Index. They can provide investors with decent relative income over the next year, when economic growth is likely to 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: In our view, the strong demand and pricing power that companies have enjoyed in recent years, and the resulting record operating margins, are simply not sustainable—which is something that stock investors have been slow to admit. 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. Although many sectors have factored this in, mega-cap secular growth stocks are likely to still hold risk.

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

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 17, 2022, “Bear Market Act II.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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