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Throughout January, the stock market soared as investors began to price in a “soft landing” for the economy—predicting the Federal Reserve would be able to tame inflation without sparking a recession. But Lisa Shalett, Morgan Stanley Wealth Management’s chief investment officer, warned Tuesday that “looking through the fog” to a new bull market is a bad idea.
After the U.S. economy added more than half a million jobs last month, pushing the unemployment rate to a 53-year low of 3.4%, and retail sales jumped 3%, surpassing economists’ expectations, Shalett fears the Fed will have to keep interest rates “higher for longer” to cool the economy and quash inflation.
“With consumption and inflation reheating, risks of a hard landing resembling a boom/bust are growing, even if the pain may be delayed a quarter or two,” she warned in a Tuesday note.
Recent strength in consumer spending and the labor market, along with better than expected corporate earnings, has led many investors to believe stocks are headed for a “Goldilocks scenario”—in which the economy is not too hot or too cold and where valuations remain high. But Shalett said that will only work if inflation continues to decline. And the latest consumer price index (CPI) and producer price index (PPI) data no longer show “speedily declining inflation,” according to the CIO.
Although year-over-year CPI inflation fell from its June 40-year high of 9.1% to 6.4% in January, it still remains well above the Fed’s 2% target rate. And PPI inflation—which measures changes in wholesale prices for businesses—came in at 6% last month as well, illustrating price increases may be here to stay.
Shalett warned that this data means Fed officials will “face even more pressure to cool demand” with interest rate hikes throughout 2023, noting that consumers’ inflation expectations have risen this month as well. Economists carefully monitor inflation expectations for signs that rising prices have become entrenched in consumers’ psyche, which makes them more difficult to fight.
That means investors betting on a “Fed put”—or a swift return to low interest rates as inflation cools—are “apt to be wrong this time,” Shalett said.
“We caution that recent gains look extremely fragile,” she added. “Fed credibility is on the line, and it is likely to risk overshooting rather than quitting the inflation fight too early.”
Morgan Stanley’s base case is for the S&P 500 to end the year at 3,900, or roughly 2.5% below current levels, but the bank’s analysts believe it won’t be a straight path to get there. The index could fall as far as 3,000 this year before recovering.
Shalett warned against “buying the dip” in this environment, and recommended investors focus on stocks that offer dividends and have strong free cash flows in these turbulent markets.
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