Markets are pricing in that Fed is not making a policy mistake – Morgan Stanley

Morgan Stanley equity strategists interpret the Federal Reserve’s dovish pivot as a proactive move to avoid delaying policy shifts, risking a belated attempt at achieving a soft landing.

They deem this a positive development for stocks, emphasizing the central bank’s focus on sustaining growth over obsessive inflation control.

“This is a bullish outcome for stocks,” analysts said in a client note.

While acknowledging the potential for inflation resurgence, the strategists believe this shift is welcomed by equity investors, particularly considering the bond market’s favorable response.

The market’s confidence in the Fed’s decision is evident, with investors viewing it as a prudent step. Powell’s dovish pivot serves as a catalyst for pursuing higher valuations, and markets seem to have anticipated this transition.

The strategists note that growth data monitoring is crucial to gauge the impact of policy shifts and lower yields. In the past month, there has been notable breadth improvement, with the equal-weighted S&P 500 outperforming the cap-weighted benchmark.

“This is an encouraging sign. It will be important to see this dynamic continue as we progress beyond year end and into 2024.”

While historical data may not support sustained small-cap outperformance with rate cuts, analysts believe that if early monetary policy changes amid a robust economic backdrop lead to a cyclical rebound in nominal growth, small caps could be compelling over the long term.