Get Latest Business News from All Over the World 24/7 throughout the Year: Morgan Stanley says investors seem to believe the Fed can engineer a 'soft landing' for the economy

Investors seem to be confident the Federal Reserve can engineer a "soft landing", Morgan Stanley's Lisa Shalett said.
But there are 3 reasons to doubt its rate hikes will tame inflation without sparking a recession, the CIO said.
These are overvalued US stocks, the shrinking Fed balance sheet, and misplaced faith in the Fed "put".

Investors shouldn't be too optimistic that the Federal Reserve can pull off a "soft landing", Morgan Stanley's Lisa Shalett has warned.

There are signs the market is confident the US central bank can bring down red-hot inflation without sending the economy into a recession.

But could well be wishful thinking, Shalett suggested to clients in a note this week.

Stocks have risen even after the Fed in March hiked interest rates for the first time since 2018, and they have erased recent losses from the Russia-Ukraine conflict, she noted.

The rally is being driven by higher appetite for risk, rather than short covering, according to the Morgan Stanley Wealth Management CIO.

"These developments indicate markets may be counting on a 'Goldilocks' scenario, where policymakers tame inflation with limited damage to economic growth and keep long-term rates low by historical standards," she said.

"We don't think such market confidence is warranted."

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

But economist Mohamed El-Erian and other key figures doubt the Fed's ability to deal effectively with inflation, which is at a 40-year high in the US, and many fear a recession.

Shalett gave three reasons the market shouldn't 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 the price-to-earnings ratio is high, compared with levels in past periods of high inflation.

Shalett noted that whenever consumer price inflation was between 6% and 8% in the last 70 years, the P/E ratio was 12, on average, compared with a multiple of 20 today.

At the same time, the return premium that stock investors get for taking risk seems lower, she said. This is despite growing risks including geopolitical friction and a maturing business cycle.

Russia's invasion has rattled stock markets already unsettled by the prospect of a Fed monetary policy shift, and US indexes have just notched their first losing quarter since 2020.

Fed balance sheet

Second, there's a chance markets aren't properly pricing in the impact of the Fed cutting back on asset purchases and shrinking its balance sheet.

The central bank is poised to rein in this aid it provided — alongside keeping interest rates low — to sustain the economy during the pandemic. But it has not laid out its intended timing or pace.

Yet financial conditions have already tightened, Shalett said. At least $560 billion is expected to be withdrawn over the year, equivalent to another rate hike of 25 basis points.

"The Fed has limited experience with these operations, and execution risk is high," she said.

The Morgan Stanley CIO noted it abandoned its last balance-sheet reduction move in 2018 when markets turned highly volatile.

Misplaced faith in Fed 'put'

Third, there are hopes in the market for a Fed "put" — the idea the central bank will intervene to limit a slide in stocks once they fall to a certain level.

But the hawkish tone from officials, who could be eyeing hikes of 50 rather than 25 basis points, means they may be misguided, Shalett said.

"It's possible that some of this positioning may be politically driven, but there is growing potential that the central bank will need to prioritize taming inflation over backstopping markets," she said.

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

Against this backdrop, investors should consider Treasuries and growth companies, Shalett said.

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