END TO THE BEAR MARKET Q4?

Investors seem to be without clear direction after the Federal Reserve’s third straight interest-rate hike of 75 basis points, combined with its surprisingly hawkish forecast for more walks in coming months.

Meanwhile, conflicting signals from economic data are compounding investors’ uncertainty. On the one hand, leading indicators, such as Treasury yield curves, suggest the increasing likelihood of a recession in the year ahead. Inverted yield curves, which occur when long-term debt has lower yields than the short-term debt of similar quality, indicate that bond investors are pessimistic because they expect long-term interest rates to decline, which is generally associated with recession. For example, the 2-year/30-year curve is the most inverted since 2000, with 2-year Treasury yields 51 basis points higher than 30-year Treasury yields.?

On the other hand, lagging indicators such as retail sales, manufacturing-activity gauges and labour-market data suggest potential resilience in third-quarter earnings results and a pickup in economic growth.?

Stock investors may underestimate the leading indicators while putting too much weight on the lagging ones. Morgan Stanley’s Global Investment Committee believes this bear market is far from over and recommends that investors consider fundamental dynamics to inform their equity investments.

• The Fed’s resoluteness:?The U.S. central bank is on one of its most aggressive tightening paths; it has never raised rates this quickly in nine months. But over the past 13 years, investors grew used to meagre interest rates and a patient Fed, if not outright supportive. This has left many stock investors today underestimating the central bank’s resolve to raise rates. And in turn, the market’s continued expectation of a dovish pause or a pivot by the Fed has pushed Chair Jerome Powell to reiterate his conviction via strong rhetoric and aggressive forecasts.
• The persistence of core inflation:?The headline consumer price index was up 8.3% year-over-year in August, a slight deceleration from the 8.5% pace observed in July, due in part to declining commodity prices. And the September reading, as projected by the Federal Reserve Bank of Cleveland, could inch down to 8.1%. But core inflation—the Fed’s particular focus—was higher than expected and is unlikely to abate anytime soon, given intense price pressures from the services side, such as wages and rents, which tend to be slow to change. If core inflation stays higher, so will interest rates.
• Policy lags:?The impact of monetary policy on the economy and corporate profits comes with long lags. Current levels of growth in the national gross domestic product and, in turn, third-quarter corporate earnings reflect where interest rates and financial conditions were nine to 12 months ago. This means investors could be getting a false sense of security from whatever earnings potential they see in stocks today.

Simply put, the paths for interest rates, inflation and corporate profitability remain uncertain. That’s why stock investors should demand a more significant premium for risk-taking. In other words, stocks still look expensive, and valuations look high, especially given that inflation-adjusted yields have increased.?

Investors could be in for more surprises as they overlook the impact of tightening financial conditions. They should be cautious about investing in long-duration or growth-oriented equities, which currently may not offer fair compensation for the risks of rising rates, weakening operating leverage and the strong U.S. dollar. Any bear-market rally that may occur in the seasonally strong fourth quarter should be used for rebalancing portfolios and tax-loss harvesting.