Morgan Stanley CIO: Stock Market 'Full of Wishful Thinking'

Despite the Federal Reserve’s aggressively raising interest rates to fight inflation, “the stock market isn’t taking the Fed at its word. The stock market is in denial, saying, ‘Aw, they’re just being too hawkish; ultimately, they’re going to capitulate,” argues Lisa Shalett, chief investment officer of Morgan Stanley.

“But the Fed is signaling an unequivocal seriousness that they’re willing to risk a recession to get the job done,” she adds.

Calling the market “a roller coaster to nowhere” for the past four months because of high volatility, in the interview she argues that it “continues to be full of wishful thinking that ultimately the Fed is going to realize they’ve done too much and will pause and pivot.  

“But the Fed is saying, essentially, ‘We’re not going to behave in a way that pleases the equity market,” she says. “We’re going to do what we said we were going to do — and that is to tame inflation.” 

Shallett, who runs Morgan Stanley’s global investment office, provides advice and guidance to clients and advisors regarding long-term goals-based planning and portfolio construction, among other guidance based on the office’s original research.

Describing herself and her team, she says: “We are the owners of advice.”

The Harvard Business School MBA joined the firm nine years ago and has been CIO since 2019.

In our conversation, she holds that the stock market “has this Goldilocks scenario, where the Fed raises rates, inflation is tamed and the economy slows — yet corporate earnings are basically unscathed.

“Our position is that valuations in the market remain unappealing,” she says. “They’re still too high.” 

Shalett anticipates that corporations will “reset” their earnings expectations next month.

Until then, “It’s going to be a rocky couple of weeks,” she predicts.

But she expects the U.S. economy “to prove to be more resilient than what the [government bond] yield curves are telling you — that the risks of recession are going up.”

In the interview, she also provides her forecast for the rate of core inflation by the end of next year.

ThinkAdvisor interviewed Shalett on Wednesday, following Federal Reserve Chair Jerome Powell’s speech at the Fed meeting that day.

She was speaking from her midtown Manhattan office.

In a brief sidebar chat about women in financial services, she talks bluntly about why women are “better investors” than men and gives her upbeat forecast for more women becoming advisors.

Here are highlights of our interview:

THINKADVISOR: When do you foresee the stock market bottoming?

LISA SHALETT: My crystal ball isn’t that precise. But the period in October of third-quarter earnings is going to represent a pivotal inflection point where corporate management has to acknowledge that earnings are at risk.

At that point, we reset earnings expectations. And that is when you can put in a more durable bottom, when expectations are more realistic.

We’re close in terms of the calendar, but it’s still going to be a rocky couple of weeks.

What’s your reaction to [Federal Reserve Chair] Jerome Powell’s statement today about inflation: “We want to act aggressively now and get this job done, and keep at it until it’s done.” And he announced a big interest-rate increase of three-quarters of a percentage point.

The bond market has taken him a bit more seriously than the stock market.

The stock market has continued to be full of wishful thinking that ultimately the Fed is going to realize they’ve done too much and will pause and pivot.

How would you describe the Fed’s approach?

They’re being very disciplined central bankers, saying [in essence]: “We’re not going to behave in a way that pleases the equity market. We’re going to do what we said we were going to do — and that is to tame inflation.

With their “dot plot” [projection for interest rates] and their growth forecast, they’re signaling an unequivocal seriousness that they’re willing to risk a recession to get the job done.

What’s your assessment of stock market activity over the last months?

The market has been on a roller coaster to nowhere. The reality is that the S&P 500 at 3,789 is still above the June trough, which was a very typical, standard bear market pullback.

Yes, bear markets are painful. But are we setting new records? Absolutely not. It’s a market that has been incredibly volatile but essentially moving in place for the past four months.

What are investors worried about most right now?

I think the stock market is still full of wishful thinking about Fed behavior, as I’ve said.