• Lisa Shalett, the CIO of wealth management at Morgan Stanley, said in a note last week that stock investors have been too optimistic.
  • She argued that recent strenght in stocks may be a bear-market rally driven by "wishful thinking" and excess liquidity.
  • Shalett laid out three risks, including Fed policy tightening, higher rates, and macroeconomic headwinds.

Investors should be wary of stock-market stability off recent lows, says the CIO for Morgan Stanley's wealth management division.

"Recent strength in the equities market may be nothing more than a bear-market rally, fueled by wishful thinking and excess liquidity," Lisa Shalett wrote in a recent report.

Despite a rocky week, global stock indexes are still up markedly from recent lows, with the S&P 500 and tech-heavy Nasdaq 100 having gained more than 3% over the past month. But both benchmarks are still down big on the year as investors have grappled with sky-high inflation, rocketing commodity prices, and a series of rapid US rate increases.

Shallett said the gains seen so far in April were down to investors hoping the Federal Reserve would engineer a "soft landing" by raising rates quickly enough to cool inflation but without sending the economy into a recession. 

The Fed raised interest rates in March for the first time since 2018, taking a big step to tame inflation at its highest for 40 years in the US, and planned a series of at least six more hikes this year. Markets are pricing in expectations for a 50-basis point hike from the Fed's next meeting in May and possibly more at subsequent meetings. 

The Fed is also expected to shrink its balance sheet by $95 billion a month, according to its most recent meeting minutes. Futures markets show investors believe US rates could be as high as 2.75% by the end of this year, compared with 0.5% right now.

Shalett said she disagrees with the view that investors seem to hold that the Fed hiking interest rates wouldn't affect stock valuations, and were ignoring macroeconomic risks from the Russia-Ukraine war and slowing growth.

"Morgan Stanley's Global Investment Committee disagrees with these sanguine views and believes some of the more cautious signals coming from the bond market may better reflect the likely path ahead," she said.

For starters, she said the Fed is expected to raise rates more times than market expected three months ago and would cut billions more a month than expected from its asset holdings.

"Such aggressive tightening will make the Fed's policy execution highly complex, and historical examples suggest that even when the central bank does manage to land the economy softly, markets often feel a much harder impact," she said.

In her opinion, investors are underestimating the potential hit to the stock market from a series of rapid rate rises and the effect those have on the underlying economy.

"This may be wishful thinking. We believe the Fed is apt to tighten policy more than many investors expect, impacting real rates and valuations as a result," she said.

Lastly, Shalett said input costs, including wages, are still rising for companies, US growth will slow and there is a real risk of recession in Europe stemming from Russia's war in Ukraine, especially if the single currency bloc halts imports of Russian energy.

With all that in mind, the double-digit gains of 2020 and 2021 will be harder to pull off, she said. 

"As financial conditions tighten, a strong but slowing economy is unlikely to be enough to power substantial passive index gains from here," she said.

Read the original article on Business Insider