Geopolitical strife and monetary-policy tightening have knocked financial markets off balance, but the U.S. economy may be on sounder footing. What this divergence means for investors.
Amid the continuing war in Ukraine, daily market volatility, and both higher oil prices and aggregate commodity indices (for sectors such as energy, metals and agriculture), investors are rightly worried.
This is the stuff of classic supply shocks that lead to stagflation, where inflation remains high and growth slows. Perhaps even more worrisome, say some investors, the prospect of an inverted U.S. Treasury yield curve may signal potential recession.
It is precisely into this complicated and volatile environment that the U.S. Federal Reserve will have to tighten its monetary policy. Usually central banks can respond to a supply shock with policy accommodation, as the U.S. Fed did in 2020 to address pandemic-related business shutdowns. But the U.S. Fed has already played its cards on easing policy. Having announced plans to tighten monetary policy with interest rate hikes and balance sheet reduction, the U.S. Fed now has little room to change course.
In such circumstances, investor concerns are understandable. However, we think the implications for financial markets and the economy will likely differ:
- For markets, we see significant headwinds as financial conditions tighten alongside rising rates. Stocks and bonds alike remain priced relatively high at the index level and are extremely sensitive to the federal funds rate. Expectations for corporate earnings are high too, even though rising costs across inputs, logistics and labour are likely to hurt profitability. In fact, corporate outlooks for future performance have begun to disappoint, with the highest proportion of companies issuing negative earnings guidance since 2016.
- The economy, however, may prove a bit more resilient. We see economic growth over the next two years remaining well ahead of the average of the last decade. Here are some reasons why:
- Growth is decelerating, but from a very high level.
- Credit capacity and cash balances are plentiful for households, corporations and the banking system.
- The economy is much less sensitive to interest rates than markets.
- The labour market remains tight and wage-gain prospects rosy.
- Incentives for fiscal spending are growing.
A routine adage on Wall Street is that “the economy is not the market, and the market is not the economy”—and rarely has that reminder been more important, given their starkly different starting points heading into the next part of the cycle.
When prospects for the economy and the market diverge, active management is the order of the day. Unlike the old days when investors, amid a slow-growing environment, could seek shelter in U.S. mega-cap growth-style stocks, investors today should consider remaining patient but selectively opportunistic among quality, reasonably priced names. We remain focused on financials, energy, industrials, healthcare and consumer services.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 7, 2022, “Starting Points Matter.” Ask your Morgan Stanley Financial Advisor for a copy. Plus, more Ideas from Morgan Stanley's thought leaders.