The S&P 500 has historically seen returns slashed in times of Fed tightening. Here’s what that means and which stock sectors investors should consider, according to Morgan Stanley.

• The stock market is set for leadership by defense stocks as the Fed enters a new tightening cycle.
• Morgan Stanley in a note Monday said the S&P 500 usually sees diminished returns in times of Fed tightening. 
• The S&P 500 has dropped so far in 2022 after last year’s rise of 27%. 
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The S&P 500 has stumbled at the start of 2022 after the Federal Reserve laid the groundwork to start reducing support to the US economy, moves that could dull the benchmark’s potential return and open the door to upside in defensive stocks, according to Morgan Stanley. 

After the S&P 500 finished last year up by 27%, the stock market is entering a period of tighter Fed policy as well as decelerating economic and corporate earnings growth. That typically means opportunities for healthcare and other defensive sectors to take a leadership role, the investment bank said in a note published Monday. 

“Average returns appear less attractive as the Fed moves into a tightening policy regime. In a rising Fed Funds environment, returns are lowest — 0.4% average monthly returns,” wrote Morgan Stanley equity strategists led by Michael Wilson. 

Outside of recessions, the S&P 500 tends to perform best in periods of a declining Fed Funds Rate, with an average monthly return of 1.8%, they said. 

But Wednesday’s consumer inflation report could reinforce the Fed’s recent signal that it will start raising interest rates and draw down its balance sheet faster than Wall Street had anticipated. 

As the Fed embarks on a potentially aggressive cycle of normalizing monetary policy nearly two years into the COVID pandemic, the market is now six months past the June 2021 peak in corporate earnings.  

In this environment, leadership skews more defensive. In fact, in the six to 18 months after a per-share earnings peak, the defensive consumer staples, health care, and utilities groups have recorded gains of between 10.6% and 8%, Morgan Stanley said. And the energy group does even better, with a gain of 21.5%.