Morgan Stanley

Conflicting Views on Rate Cuts

Sep 18, 2024

With this week’s widely anticipated rate cut, equity markets seem optimistic about the economy, but bond investors worry the Fed may have missed its window to forestall a recession. Who’s right?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Equity markets may expect an economic “soft landing,” but investors shouldn’t brush off bond-market signals that a recession looms.
  • Global economic growth appears fragile, uncertainty among small businesses is high, and U.S. consumers are exhausting their savings.
  • Given such risks, consider investment opportunities in financials, industrials, energy, materials, healthcare and parts of the technology sector.

With this week’s widely anticipated interest rate cut by the U.S. Federal Reserve, investors face a conundrum: Stocks and bonds appear to be sending conflicting signals about the economy’s path forward.

 

For stocks, consider that the S&P 500 Index has recovered from a mid-summer swoon and rallied roughly 8.5%, back within striking distance of its all-time high. Underpinning this rally has been an expectation among many equity investors that the economy will enjoy a “soft landing,” driven by economic growth, productivity gains and profit-margin expansion.

 

Meanwhile, bond prices have rallied as yields have plummeted, particularly shorter-term rates. As a result, the closely watched two-and-10-year Treasury yield curve, which has been “inverted” since July 2022, has rapidly “un-inverted,” seeming to imply a looming recession.

 

Remember, an inverted yield curve shows that bonds with nearer-term maturity dates have higher yields than longer-term bonds – indicating that investors may be wary of recession and are favoring longer-term bonds for their perceived “safety” from a potentially falling equity market. That pushes longer-term bonds’ prices up and their yields down.

 

However, inverted yield curves often un-invert before a slowdown hits, as investors anticipate the Fed swiftly and steeply cutting its overnight rate to support the economy. Today, market-based forecasts suggest there will be as many as 250 basis points of cuts by next December. Historically, that speed and amount has only been associated with a Fed that’s “behind the curve” in easing monetary policy.

Outlook on the Economy

Is the economy on track for a soft landing (as equity markets suggest), or has the Fed kept rates too high for too long (as bond markets seem to imply)? Morgan Stanley’s Global Investment Committee’s still anticipates a soft landing. However, we take seriously the warnings implicit in Treasury market moves, as negative surprises may be brewing in at least three areas.

Is the Fed Behind the Curve?

While equity markets may be counting on a soft landing, bond markets are signaling a potential recession. Here's why investors shouldn't dismiss the warnings.

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  1. 1
    Global economic growth looks fragile.

    Many investors have long expected an economic recovery outside of the U.S. to support U.S. stocks, given that roughly one-third of S&P 500 company profits come from overseas. That said, commodity markets may be sending worrisome cues. The recent decline in oil prices, for example, is being compared to drops seen during recessionary periods. Worse-than-anticipated data from China may also be fueling investor concern: The country remains weighed down by poor consumer confidence and weak consumption, as well as a still-tentative recovery in the residential property market. Economists have cut China’s next-year growth estimates to below the critical threshold of 5%. 

  2. 2
    Treasury investors are likely digesting weak readings from recent small-business surveys.

    These surveys suggest the level of uncertainty among small businesses, which account for about two-thirds of U.S. jobs, is around its highest since 2020. Sales expectations are at a four-year low, while hiring and capital investment intentions are also fading. Even as total U.S. non-farm payrolls remain positive, there have been net losses in small-business jobs in recent months, and bond investors may view this signal as the canary in the coal mine.

  3. 3
    Treasury investors may see vulnerability among U.S. consumers.

    Equity investors are likely encouraged by factors like robust retail sales, inflation-adjusted growth in household incomes, and improving consumer sentiment. However, as we recently noted, households have been exhausting their savings and grown more dependent on their paychecks and wage gains to continue spending. Also, defaults on consumer debt are rising. Critically, The Conference Board’s measure of whether jobs are “plentiful or hard to get,” which historically has correlated with corporate profit growth, recently shifted to a more negative outlook. 

How Should Investors Respond?

Again, Morgan Stanley remains cautiously optimistic about a soft landing. That said, conditions are fragile and uncertainty is high – a dynamic that’s complicated by the upcoming U.S. elections.  

 

This is not a time for complacency. Investors should seek out value and neutralize any assets in which their portfolios are over-invested. Consider reducing ultra-short and money-market positions and locking in still-high rates on longer-dated debt. Look to the equal-weighted S&P 500 as a better risk-adjusted exposure than the cap-weighted version.

 

Lastly, we continue to find compelling investments in financials, industrials, energy, materials and healthcare, along with parts of the technology sector like software, and think there may be more defensive ideas in residential real estate investment trusts (REITs) and utilities. Non-U.S. assets should benefit portfolios as the U.S. dollar potentially weakens.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 16, 2024, “Is the Fed behind the Curve?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation.

Ultrashort-term fixed income asset class is comprised of fixed income securities with high quality, very short maturities. They are therefore subject to the risks associated with debt securities such as credit and interest rate risk.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Companies paying dividends can reduce or cut payouts at any time.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices. Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers. Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.

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Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

The indices are unmanaged. An investor cannot invest directly in an index.  They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices are not subject to expenses or fees and are often comprised of securities and other investment instruments the liquidity of which is not restricted. A particular investment product may consist of securities significantly different than those in any index referred to herein. Comparing an investment to a particular index may be of limited use.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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