- Morgan Stanley says investors should expect higher rates and inflation over the next 12-18 months.
- The investment bank recommends sticking with value stocks despite a recent sell-off.
- Investors should neutralize style biases, trim high-priced positions, and prepare for higher rates.
- See more stories on Insider’s business page.
The Federal Reserve released its latest dot plot of fed funds rate projections at the Federal Open Market Committee meeting on June 16.
Fed chair Jerome Powell did note that dot plots should be “taken with a big grain of salt” and cautioned that conversations about raising rates at this point would be “highly premature.” The Fed also said it would continue with its aggressive asset purchases and maintain low-interest rates until further progress has been made on employment mandates.
In a note to clients on Monday, Lisa Shalett, the chief investment officer of Morgan Stanley Wealth Management, called the central bankers’ new dot plot a “surprise shift” that has left investors “dazed and confused.”
While a rotation away from growth stocks and into more value-oriented plays has been the dominant market narrative for much of 2021, investors are now “lurching between” projections of weaker growth and a hotter, reflationary scenario, she said.
According to Shalett, the weaker growth scenario would boost “long-duration secular growers” like tech shares, while a hotter, reflationary scenario would benefit “high-beta, deep-value cyclicals.”
Shalett and her team at Morgan Stanley believe the likely outcome is somewhere between these two scenarios. However, they did say the Fed will probably allow inflation to continue to run up in the near term, meaning higher rates and a hotter, shorter cycle that will produce headwinds for growth stocks.
“We think the data will point to sustainably higher economic growth, along with higher, but controlled inflation, rather than a growth slump that would rewards last cycle’s secular winners,” Shalett wrote.
According to Shalett, markets are in a “range-bound, midcycle environment” with strong earnings on the way, meaning “investors should focus on the micro, not the macro.”
“It is not time to abandon the value trade,” Shalett added.
Below are three strategies Morgan Stanley says investors should deploy as rates rise over the next 12 to 18 months.
Position for higher intermediate-term rates and inflation
“We believe it is hard to argue against prospects for both real and nominal rates to increase over the next 12-18 months,” Shalett wrote. “The Fed wants and needs inflation and is likely to stoke it.”
Morgan Stanley recommended positioning for higher intermediate-term rates and rising inflation – and it’s not the first time.
In March, Mike Wilson, the firm’s chief US equity strategist and chief investment officer, told investors in a “Thoughts on the Market” podcast to focus on companies that can benefit from rising prices and interest rates.
The CIO recommended investors look to sectors like financials, materials, and energy for beneficiaries of higher rates, while sectors like cyclicals, business services, and travel and leisure were set to outperform due to rising prices.
Neutralize extreme style biases
Over the past few months, extreme style biases haven’t been great for investors.
Take the example of growth investing. In 2020, and for much of the preceding bull market, investing in growth sectors like artificial intelligence and clean energy was a recipe for success.
But in 2021, with rate hikes on the horizon and inflation concerns persisting, extreme style biases haven’t been so rewarding. Investors have instead favored fast-growing tech stocks to cheaper value names, although the durability of this rotation remains to be seen.
Morgan Stanley recommends doing away with extreme style biases in favor of “quality” names with strong earnings.
Trim high-priced positions in favor of quality value names and growth at a reasonable price
Trimming highly valued positions in favor of names that represent “quality” is a key to navigating this tumultuous period in the markets, according to Morgan Stanley.
As interest rates rise, valuations tied to those rates often fall, meaning stocks that are highly valued based on future growth projections tend to underperform.
While picking individual value stocks can be a challenge for some retail investors, there’s another option – ETFs.
ETFs like iSTOXX American Century USA Quality Value, which is designed to select large- and mid-cap companies that are undervalued and have a sustainable income, could be an option for investors looking to protect capital by investing in value-oriented names.
There are also ETFs like the Invesco S&P 500 GARP ETF, which is based on the S&P 500 Growth at a Reasonable Price Index, that can be rewarding for investors looking to split the difference, so to speak, and take a position in growth stocks that also trade at a reasonable valuation.
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