3 reasons why investors shouldn’t buy a ‘soft landing’ from the Fed

  • Investors appear confident that the Federal Reserve can engineer a “soft landing,” said Lisa Shalett of Morgan Stanley.
  • But there are 3 reasons to doubt his rate hikes will control inflation without triggering a recession, the CIO said.
  • These are overvalued US stocks, the Fed’s shrinking balance sheet, and misguided faith in the Fed’s put.

Investors should not be too optimistic that the


Federal Reserve

may achieve a “soft landing,” Morgan Stanley’s Lisa Shalett warned.

There are signs that the market is confident that the US central bank can reduce inflation red-hot without bringing the economy to a head.


recession

.

But it might as well be wishful thinking, Shalett suggested to customers at a note this week.

Stocks have risen even after the Fed in March interest rates rose for the first time since 2018, and have erased recent losses from the conflict between Russia and Ukraine, he noted.

The rally is being driven by increased risk appetite, rather than short hedging, according to the CIO of Morgan Stanley Wealth Management.

“These developments indicate that markets may be counting on a ‘Goldilocks’ scenario, where policymakers control inflation with limited damage to economic growth and keep long-term rates low by historical standards,” he said.

“We do not believe that such market confidence is warranted.”

Aggressive comments from Fed Chairman Jerome Powell have set expectations for at least six more rate hikes in 2022, possibly by 50 basis points. That would bring the benchmark rate to just under 2%.

but economist Mohamed El-Erian and other key figures they doubt the Fed’s ability to deal effectively with inflation, which is at its highest point in 40 years in the US, and many fear a recession.

Shalett gave three reasons why the market should not be so confident in the Fed’s abilities.

overvalued stocks

The first is that US stocks look overvalued, given that earnings yields are low and price-earnings ratios are high, compared to levels in previous periods of high inflation.

Shalett pointed out that whenever consumer price inflation was between 6% and 8% over the past 70 years, the P/E ratio was 12, on average, compared to a multiple of 20 today.

At the same time, the return premium stock investors get for taking risk appears lower, he said. This is despite growing risks including geopolitical frictions and a maturing


business cycle

.

The Russian invasion has rattled stock markets already unsettled by the prospect of a change in Fed monetary policy, with US indices just posting their first negative quarter since 2020.

Federal Reserve Balance Sheet

Second, there is a possibility that the markets are not properly pricing in the impact of the Fed’s cut on asset purchases and the shrinking of its balance sheet.

The central bank is prepared to control this help it provided, in addition to keeping interest rates low, to sustain the economy during the pandemic. But it has not set the time or the pace planned.

However, financial conditions have already tightened, Shalett said. At least $560 billion is expected to be withdrawn during the year, equivalent to another 25 basis point rate hike.

“The Fed has limited experience with these operations and execution risk is high,” he said.

Morgan Stanley’s CIO noted that he abandoned his last balance sheet-cutting move in 2018 when markets turned highly volatile.

Faith misplaced in the Fed’s ‘put’

Third, there is hope in the market for a Fed “sell” – the idea that the central bank will step in to limit the fall in stocks once they fall to a certain level.

But the aggressive tone of officials, who may be considering hikes of 50 rather than 25 basis points, means they may be wrong, Shalett said.

“Some of this positioning may be politically driven, but there is a growing potential that the central bank will need to prioritize controlling inflation over supporting markets,” he said.

Morgan Stanley expects rate hikes of 50 basis points in May and June. Overall, he sees a bumpy road ahead and a rethink by policymakers about whether a soft landing can be engineered.

In this context, investors should consider Treasuries and growth companies, Shalett said.

Read more: Are we on the brink of a housing bubble bursting? An economist advises buyers to stay out of the current ‘irrational’ market and lists the 11 most overvalued cities in the US..

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