By Lisa Shalett, Morgan Stanley

For most of 2022, investors have seemed to have a single-minded obsession with the direction of Federal Reserve policy. Given the level of inflation we’ve seen, and the outsized role that monetary policy has played in driving market outcomes since 2008, this focus is understandable.

But there’s more to consider in the current market than the Fed and its fight against inflation. And we worry that a myopic, domestic focus may ignore other important dynamics that could have an impact on investment portfolios.

Earnings vulnerability

First, we continue to see risk in today’s corporate earnings forecasts. They still appear unrealisticallyhigh, especially given the recent re-affirmation from Fed Chair Jerome Powell of the central bank’s commitment to fighting inflation, even if it means inflicting some pain on the economy and corporate profits.

Consensus earnings expectations have come down a bit, but estimates for 2023 are still up 5% over 2022, and Morgan Stanley expects another leg down, of about 10%-15%. We think corporate executives and Wall Street analysts may be underestimating the potential loss of pricing power that companies will experience with further rate cuts and falling inflation, as inflation has helped keep higher nominal prices.

In addition, complex cross-currents coming from consumers’ shift from goods to services could have an impact on some sectors that have thrived during the pandemic, including retail, consumer goods and automotive. Finally, of course, the broad economic slowdown will have widespread effects.

Global complications

Also concerning is the U.S. stock market’s apparent dismissal of global dynamics. Certainly, the market has recognized the risks of the Russia/Ukraine war and the obvious implications to global energy and food prices. But with oil prices having pulled back and inflation largely seen as having topped out, we are concerned about U.S. investor complacency around global risks and opportunities having little to do with the Fed.

First, the situation in Europe bears watching

The energy crisis is getting worse, with natural gas and electricity prices soaring. This has pushed eurozone inflation rates above 9% and raised the probability of a severe recession.

The European Central Bank will likely need to begin its own cycle of rate hikes just as the economy heads in a slowdown. Incremental pressure to help destroy demand there may ultimately fall back on the Fed — a risk that does not seem priced by financial markets.

While uncertainties remain around inflation and policymaking, markets do seem to have factored in a potential recession in Europe, reflected in the euro’s weakness against the U.S. dollar and 12-year-low equity valuations relative to U.S. stocks. This could mean potential opportunities for patient, value-oriented investors.

Next, in China, the economic situation may actually be the reverse of Europe’s

While negative headlines about lingering COVID shutdowns may persist, the upcoming Communist Party Congress and the vote to elect Xi Jinping as its leader for a historic third term could set the stage for what’s likely to be a string of economic stimulus programs.

Chinese securities’ performance could also benefit from a potential resolution with the SEC of issues around shares of Chinese companies held by U.S. depositary banks. And, unlike other major markets, China has low inflation, high real interest rates and a relatively strong currency, which give the country plenty of policy flexibility.

One final note for investors is the potentially destabilizing effect of an excessively strong U.S. dollar.

While dollar strength has tempered U.S. consumer inflation, it’s also increasingly a headwind for S&P 500 company earnings and the competitiveness of American multinationals. U.S. financial assets are looking increasingly unattractive for foreign investors.

The bottom line is that investors cannot remain myopically focused on just the Fed. There are other dynamics and risks in play, and global portfolios may need to be rebalanced.

Investors should maintain global diversification, resisting the temptation to exit near the lows. In the near term, valuations for stocks outside of the U.S. are much more compelling than those for domestic equities. And in 2023, non-U.S. markets will likely present more potential for upside surprises.

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About LRPC’s Monday Morning Minute

Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in sustainable investment strategies for retirement plans that incorporate Socially Responsible Investment (SRI) factors and Environmental, Social and Governance (ESG) elements. LRPC currently has contracts in place to provide consulting services on more than a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.