After markets suffered their worst first-half-year performance in decades, stocks have bounced on hopes the Fed may ease up on monetary tightening. See why this could be wishful thinking.
Some investors today seem to think the recession is already here, or at least on its way. That’s understandable:
- A key part of the Treasury yield curve inverted recently;
- The purchasing managers’ index, which tracks service and manufacturing sectors, is declining; and
- The Federal Reserve reported first-quarter GDP growth at -1.6%, with the second-quarter GDP estimate suggesting another contraction.
With these factors in mind, investors have rotated out of credit and value stocks toward long-duration growth assets, which tend to be viewed more favorably when rates remain low or decline. These assets, which dominate benchmark equity indices, have rebounded to start July. It seems investors are declaring the market rout likely over, now that recession risks are priced in.
But is this really the “buyable bottom” of the 2022 bear market? And might the Fed begin paring back its policy tightening? We don’t think so. Here’s why:
Related articles
- WEALTH MANAGEMENTHow Bad Could the Next Recession Be?
- WEALTH MANAGEMENTHow Can Investors Prepare for a ‘Profits Recession’?
- WEALTH MANAGEMENTHow to Prepare for a ‘Late-Cycle’ Economy
- Inflation is far from being tamed. Granted, supply chains may be clearing, and energy prices are dropping. But this is partly the result of short-term fixes, such as added supply from strategic oil reserves, which could be offset quickly, especially if the $220 billion fiscal stimulus that China is mulling does come into play to shore up the country’s economy, potentially stimulating demand amid still-limited supply. In addition, even if energy-related inflation does cool, overall U.S. inflation may be slower to fall given that a significant portion of it is linked to the fast-recovering services sector, where prices for items like rent and medical services may remain stubbornly high.
- The Fed’s policy rate still has room to rise. The central bank typically does not end a tightening cycle until its policy rate is above inflation. Currently inflation is 8.6%, per the consumer price index, and 5.2%, per the Fed’s preferred personal consumption expenditures gauge. At this pace, we would need to see genuine damage to the labor market before the Fed would change course. And, as evidenced by June’s job report—employers added 372,000 jobs, above estimates, and the unemployment rate held at 3.6%, near a 50-year low—the market remains robust.
- Consumer and corporate spending outlooks are strong. Though consumer confidence and CEO sentiment are weak, consumer behavior has not changed. Households’ cash and money market deposits, estimated at about $2.3 trillion, could cushion balance sheets and consumption. In addition, corporate capital-spending intentions have remained strong, durable goods orders have continued to beat expectations, and housing-sector activity levels are nowhere near recessionary. Such economic resilience would likely suggest the Fed’s current hawkish path can continue.
We believe it is too early to price in an imminent recession. More likely, we’ll see “stagflation,” where growth slows but is nominally positive, inflation stays higher for longer and financial markets continue to face volatility.
For more realistic clues about the pace of Fed policy, investors should watch second-quarter earnings guidance and labor-market data. In the meantime, with another 5% to 10% downside likely in stocks, consider connecting with your Morgan Stanley Financial Advisor to neutralize major overweight and underweight positions, harvest losses in your portfolio for potential tax reductions and pursue maximum asset-class diversification.