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Investors seem to be confident the Federal Reserve can engineer a "soft landing", Morgan Stanley's Lisa Shalett said.
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But there are 3 reasons to doubt its rate hikes will tame inflation without sparking a recession, the CIO said.
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These are overvalued US stocks, the shrinking Fed balance sheet, and misplaced faith in the Fed "put".
Investors shouldn't be too optimistic that the Federal Reserve can pull off a "soft landing", Morgan Stanley's Lisa Shalett has warned.
There are signs the market is confident the US central bank can bring down red-hot inflation without sending the economy into a recession.
But could well be wishful thinking, Shalett suggested to clients in a note this week.
Stocks have risen even after the Fed in March hiked interest rates for the first time since 2018, and they have erased recent losses from the Russia-Ukraine conflict, she noted.
The rally is being driven by higher appetite for risk, rather than short covering, according to the Morgan Stanley Wealth Management CIO.
"These developments indicate markets may be counting on a 'Goldilocks' scenario, where policymakers tame inflation with limited damage to economic growth and keep long-term rates low by historical standards," she said.
"We don't think such market confidence is warranted."
Hawkish comments from Fed Chair Jerome Powell have set expectations for at least six more rate hikes in 2022, possibly of 50 basis points. That would bring the benchmark rate to just below 2%.
But economist Mohamed El-Erian and other key figures doubt the Fed's ability to deal effectively with inflation, which is at a 40-year high in the US, and many fear a recession.
Shalett gave three reasons the market shouldn't be so confident in the Fed's abilities.
Overvalued stocks
The first is that US stocks look overvalued, given that earnings yields are low and the price-to-earnings ratio is high, compared with levels in past periods of high inflation.
Shalett noted that whenever consumer price inflation was between 6% and 8% in the last 70 years, the P/E ratio was 12, on average, compared with a multiple of 20 today.
At the same time, the return premium that stock investors get for taking risk seems lower, she said. This is despite growing risks including geopolitical friction and a maturing business cycle.
Russia's invasion has rattled stock markets already unsettled by the prospect of a Fed monetary policy shift, and US indexes have just notched their first losing quarter since 2020.