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, Wealth Management, at 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.” 

Shalett, 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.

The market isn’t taking the Fed at its word. The bond market takes the Fed at its word — that it’s going to raise rates to 4.4% before the end of the year and raise them another 25 basis points during calendar year 2023. 

There is no mention of cuts in that scenario.

The bond market is trying to price it [in]. But the stock market is in denial, saying, “Aw, they’re just being too hawkish. Ultimately, they’re going to capitulate.” 

What’s your forecast for the stock market for the rest of the year?

The stock market is ahead of itself in the idea that we’re going to have 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 this market remain unappealing: They’re still too high, probably by 10% or 15%. That’s the amount corporate profits need to get cut.

What’s your forecast for the U.S. economy?

The economy is going to prove to be more resilient than what the yield curves are telling you.

Today it was all about the yield curve — all about the bond market, that near-term rates are going to go up a lot but that long-term rates, like the 10-year and the 30-year [Treasurys] are going to go down. 

That means the risks of recession are going up.

We’re now at the most inverted yield curve ever. That says the bond market is scared of what the Fed is going to do, and the Treasury market continues to sell off. The bond market in large part has shrugged that off.

What are your views on inflation?

Inflation is the only thing the Fed cares about in the near term. Folks have been shocked that the labor market has proven more resilient, and that has given the Fed room to really fight inflation.

Ultimately, we think that, mathematically, inflation will come down, absent additional external shocks like another war or world event.

Probably core inflation will be something in the 3.5%-4% range by the end of next year.

That’s better than where we’re at. But it’s still not quote-unquote a done deal. But we think it will probably be good enough for the Fed.

This might be a sexist question, but are there any advantages to a woman being a CIO?

Yeah, women are better investors. Full stop.

The data has shown it. There’s been study after study since the mid-1950s. I’m not kidding around.

As we know, the key to investing is risk management. It isn’t knowing when to buy the hot [stock] or to chase the thing that’s going up. Anyone can do that.

The key to investing is risk management and knowing when to sell.

Inherently, women tend to be more deliberative, less risk-oriented and therefore better at risk management overall.

Women portfolio managers consistently outperform their male colleagues, even though we’re outnumbered on Wall Street 8 or 9 to 1.

But if women are better investors than men, why aren’t there more women financial advisors?

I think more and more women are financial advisors. The financial advisory profession is a wonderful entrepreneurial endeavor that requires a multitude of skills: interest and competence in markets, building trusted relationships, managing a business. 

It’s a career that [offers] flexibility because it’s not a purely sit-behind-a-terminal-and-show-up-at a-place-9-to-5-type of role.

So I do think we’ve attracted a lot of women.

But look, it’s a very hard, very competitive game, and it’s really only in the most recent generation where women control more money than men.

Do you foresee any sizable increase in the number of female advisors in the near future?

I think that over the next 20 years, there will be more and more very, very successful women financial advisors for the reason that women like working with women — in the way that “likes” like working with “likes.” 

[Another reason is] the fact that the baby boomer generation is likely to empower more and more female decision-makers as controllers of wealth. Today, women control more wealth on paper than men do.

That will manifest itself in the ranks of financial advisors.