Investors should shift their focus from Fed rate hikes to consumer activity and the health of the U.S. economy.
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U.S. stock investors have fixated on the Federal Reserve for most of 2022, waiting for the rate hikes aimed at fighting inflation to end. Recent signs of cooling inflation encouraged investors, pushing the S&P 500 Index up 14% since a low in October. Meanwhile, Treasury rates have fallen notably, reflecting expectations for both lower inflation and lower inflation-adjusted interest rates.
However, by focusing only on Fed policy and expectations for lower rates, investors are missing the troubling implication of the policy tightening: an economic slowdown.
The U.S. economy is likely to start feeling the effects of this year’s policy tightening in earnest in 2023, since the economic effects of changes in monetary policy tend to lag by about six to 12 months. Morgan Stanley expects 2023 GDP growth to be soft, with corporate sales volumes, pricing power and profits likely taking a hit. Yet current earnings expectations and stock valuations don’t seem to reflect this outlook.
At this point, we think investors should shift their focus from the Fed’s rate hikes to consumer activity.
That’s because consumer spending, which makes up two-thirds of U.S. economic activity, will likely determine the timing and depth of the economic slowdown. It’s also likely to influence the timing of actual interest-rate cuts, which historically have been a more reliable sign of the end of a bear market.
In talking about consumption, we need to first acknowledge that the U.S. consumer has been extremely strong in 2022:
- The labor market has remained resilient, with the unemployment rate at 3.7% in November, only slightly above the 50-year low.
- Wage growth, though not completely offsetting inflation, has been solid, at a 5-6% annual clip.
- Personal spending has held up, with October data suggesting an annual pace of real consumption of about 6%.
- Inflation-adjusted retail sales growth has stayed above the trend since 2015.
Still, some warning signs of a coming slowdown are flashing:
- The personal savings rate, once boosted by fiscal stimulus relief, has plummeted from a peak of 33.8% in April 2020 to 2.3% in October 2022—the lowest it’s been since 2005.
- Credit card revolving debt has surged to an all-time high, at nearly $1.2 trillion.
- The number of new job listings is declining, as reflected in the Job Openings and Labor Turnover Survey. There were 10.3 million vacancies for October, the latest monthly data available, down by 760,000 from a year ago.
- The same survey also showed a downtrend in the “quits” level, edging toward 4 million, compared with the record 4.5 million in March 2022. This suggests people are less confident about their prospects for finding employment elsewhere.
Putting all this together, we believe labor-market and consumer-spending data bear watching, as they will help determine what is next for the U.S. economy. What's important for investors to grasp is that a growing anxiety about a slowing economy does not seem to be factored into current stock valuations and earnings expectations. And since bear markets driven by policy don’t typically end until earnings estimates reach a trough and the Fed actually starts cutting rates, this means we are likely to be waiting awhile before this bear market in equities is truly over.
Going into the end of the year, we recommend investors consider harvesting losses for potential tax benefits and focusing on income. It may make sense to re-invest proceeds into yield-producing assets, such as Treasuries, municipals, corporate credit, master limited partnerships (MLPs) and residential real estate investment trusts (REITs).
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from December 5, 2022, “Focus on the Consumer, Not the Fed.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.