This latest rally is full of 'wishful thinking' and stocks have further to fall as the Fed fights inflation, Morgan Stanley says

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Lisa Shalett is the chief investment officer for Morgan Stanley Wealth Management.Lisa Shalett

  • Stock market bulls are guilty of “wishful thinking”, according to Morgan Stanley.

  • The bank expects the Federal Reserve to continue tightening monetary policy until inflation drops.

  • Morgan Stanley Wealth Management’s Lisa Shalett expects July’s bear market rally to fizzle out soon.

Investors should brace for further Federal Reserve hawkishness that will likely cause July’s stock market rebound to fizzle out, according to Morgan Stanley Wealth Management.

The S&P 500 has climbed just under 5% since July 1, but now looks significantly overvalued with inflation set to remain high, one of the bank’s investing chiefs said in a recent research note.

“Stock market pricing seems premature,” Morgan Stanley Wealth Management’s chief investment officer Lisa Shalett said. “The latest bear market rally in our view is full of wishful thinking.”

Bullish investors have pointed to signs that inflation has peaked after hitting a 41-year high of 8.6% in May. Falling inflation would allow the Fed to ease off on its aggressive interest rate hikes, after it raised rates by 75 basis points for the first time since 1994 at its last meeting.

But Shalett warned that the US central bank has historically only started loosening monetary policy once the core personal consumption expenditure index, the Fed’s preferred measure of inflation that excludes more volatile food and energy prices, has fallen below its target interest rate.

“Equity investors are conflating a peak in the acceleration of Fed policy with an end to Fed tightening,” she wrote. “History suggests inflation needs to peak before the Fed will stop tightening.”

Core PCE rose by 4.7% in May, meaning it still significantly outpaces the target funds rate, which is expected to rise to 2.5% when the Federal Open Market Committee concludes its July meeting on Wednesday.

A hawkish Fed would likely pose a significant headwind for stocks, as rising interest rates tend to hit companies’ earnings. Shalett expects earnings results to continue to disappoint for the rest of 2022.

“We doubt that even if the Fed ends its tightening campaign with a fed funds rate of 3.2% in December that next year’s earnings will deliver the 8% year-over-year growth that is currently forecast,” she said.=

As well as the Fed’s latest monetary policy meeting, tech giants including Alphabet, Apple, and Microsoft will all release their second-quarter earnings reports this week.

Read more: Tesla earnings: Time to top-up on shares in Elon Musk’s car maker or bail out? 3 experts weigh-in on its prospects and reveal an updated price target.

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