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US stocks cheer Fed's last rate hike but Morgan Stanley cautions over-optimistic investors

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The US Federal Reserve hiked interest rates by another 75 basis points last week and has not ruled out another such hike in the next meeting of the Federal Open Market Committee (FOMC).

US stock markets have soared higher in the last one week since the US Federal Reserve hiked interest rates by another 75 basis points. NASDAQ has zoomed 10% while S&P 500 is up more than 5% and Dow Jones has soared 3%. However, Lisa Shalett, Chief Investment Officer, Morgan Stanley Wealth Management is questioning whether investors are being over-optimistic and missing the dangers that may lie ahead. "Such a reaction is curious, given that the Fed did not appear particularly dovish with its latest decision, nor did it signal a coming pivot from its aggressive tightening path," Shalett wrote in a post. She added that markets may be seeing only what they want to see. 

The US Federal Reserve hiked interest rates by another 75 basis points last week and has not ruled out another such hike in the next meeting of the Federal Open Market Committee (FOMC). Analysts believe the hike by the US Fed was in line with expectations and hence markets rallied. Lisa Shalett too sees some reason for the Fed to ease off on the policy. For starters, she does see the inflation cooling off and commodity prices in a bear market. The drop in US GDP for the second quarter straight also augurs well for the easing in policy stance argument. 

Fed in uncharted territory?

"But we doubt the narrative is quite so simple. As we've noted multiple times, there may be more headwinds and volatility ahead that aren't priced in," the Morgan Stanley CIO said. Shalett has highlighted two key concerns that she believes investors need to keep in mind before being overly optimistic. "Remember, we are in the midst of the most aggressive Fed tightening cycle in more than 40 years, with rates having risen more than 2 percentage points in the past four months and on track to rise more before the program is over," she said while arguing that policy operates with a lag, and the full economic impact of the hikes is yet to be seen.

Also Read: US stocks snap two-day losing streak on strong corporate earnings; treasuries trim losses

The US Federal Reserve has tightened interest rates and trimmed its balance sheet as well — something the central bank has never navigated before. "This remains a challenge, and the implications of higher rates and tighter financial conditions are still in front of us," Lisa Shalett said. 

Headwinds galore

The Russia-Ukraine conflict, China's economic recovery and covid still remain factors that are beyond the control of the US Federal Reserve. With the labour markets still strong in the US many argue Uncle Sam might still not be in a recession and that the Fed will continue on its tightening path. Such factors could continue to hinder corporate profitability. "Given the magnitude of these unknowns, we think the recent market sentiment may be overly optimistic," Shalett noted.

Also Read: After 2.25% rate hike in 2022, what's next for the US Fed - Find out

Valuations are also not seen to be particularly attractive to lure investors in. The equity risk premium, the excess potential return over a risk-free rate that investors may get for taking on the higher risk of stock investing — is around 3%. "During times of Fed tightening, the historical data point to ERPs above 4.5% as attractive entry points. We would prefer to wait for wider premiums that more appropriately value the true uncertainty in today's environment," the Morgan Stanley CIO wrote. She further advised investors to avoid big changes to asset allocations that differ from long-term risk-based targets.

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