The Fed’s fight against inflation is working, but it’s taking a toll on the economy and corporate profits. Learn how investors should consider positioning portfolios as market sentiment shifts.
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Wall Street can be counterintuitive, with investors reading bad economic news as “good” news for stocks. That’s because developments like slowing economic growth or surging unemployment can lead to more stimulus, even if the implications may be grim for households and Main Street.
Cheering bad economic news—and, conversely, viewing good economic news as bad for stocks—has been the general investor reaction in recent months. And to start off 2023, investors sent stocks higher based on encouraging news on inflation and a hope that the Federal Reserve could soon end its rate-hiking program as the economy slows. Equities did take a hit last week, with softening economic data pointing toward the threat of a downturn, but they rallied again to wrap the week, helped along by Fed official comments backing a moderation of rate rises.
Morgan Stanley’s Global Investment Committee agrees that inflation data have been encouraging. However, investors can no longer afford to focus only on the good news of declining inflation or central bank action, while failing to fully discount weakening fundamentals in the economy. These include:
- Continued softening in manufacturing. The ISM Manufacturing Index continued to weaken in December, hitting 48.4. Readings below 50 suggest the sector is generally contracting. This latest data point is the worst reading of the current market cycle, and there is no reason to expect a quick turnaround, regardless of what the Fed does.
- Surprising weakness in services. The ISM Services Index fell short of expectations, dropping to 49.6 for December against estimates of 55.0 and from the prior month’s 56.5. This is the first time the services index has come in below 50 during this cycle.
- Slowing consumption. Retail sales are also weakening, with December’s results, excluding gasoline sales, down 0.8%. That comes after a 0.9% decline in November. In terms of volume, consumption growth in the fourth quarter 2022 slowed to just half of what it was in the third quarter. This might explain the bulging general merchandise inventories in stores and warehouses.
When it comes to monetary tightening to fight inflation, there are two sides to the story: the positives of wrestling inflation back to the Fed’s target and the reality that a higher cost of capital is slowing the economy. Investors would be remiss to celebrate the first without contemplating the consequences of the second, especially on corporate earnings.
With traditional recession indicators still flashing red, we reiterate our caution and our recommendations for diversification, income and, most of all, patience. Investors should focus on income generation while waiting out this period of high uncertainty. To that end, consider owning short- to intermediate-term Treasuries, municipal bonds and investment-grade corporate bonds. On the equities side, look to dividend-growth stocks that exhibit above-average yields and decent earnings achievability amid an economic slowdown.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from January 23, 2023, “Good News, Bad News.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.