A government shutdown could lead to unexpected ripple effects coming into the markets: Managing Director

Kathy Entwistle, Managing Director at Morgan Stanley, joins Yahoo Finance Live to discuss expectations for D.C. legislations this week, the looming government shutdown, and taking a defensive approach to the market.

Video transcript

- I want to welcome into the show Kathy Entwistle now managing director at Morgan Stanley. Kathy, I actually want to start with what's happening on Capitol Hill and how concerned investors should be. We have a possible government shutdown looming, the debt ceiling deadline fast approaching, what are your expectations of that legislation passing, and what might, might that all mean for investors?

KATHY ENTWISTLE: Well, we did see a couple of years ago right when the government shutdown and the reaction that happened then which was not positive for the markets immediately or right away. And people don't like uncertainty and the markets certainly don't like uncertainty either. So I think that Capitol Hill they're going to have to get their act together and get this solved one way or the other because this happened last time before a pandemic. Post-pandemic or during pandemic I think would be a terrible time to let the government shut down, and there could be ripple effects that we're not expecting to come into the market. So again, I think they need to get their act together and get this resolved.

- Now Kathy, I know you are calling for a mid-cycle correction. Talk to us about when you see that happening, how severe might it be, and what's the catalyst going to be for at least a 10% drop here?

KATHY ENTWISTLE: Yeah, that's a great question, Alexis. And we've been looking for this 10% mid-cycle correction for a little bit now and we've been surprised with tech and some other areas of the market continuing to move forward. But we think this is a little bit of perception and people aren't taking into account the fundamentals in the market. And our process basically is telling us the risk rewards remain unattractive right now at the levels that we are giving slowing growth and rising rates. And then we've got other issues coming into play, such as potential increase in corporate taxes as well as we've got labor issues and we've got supply chain issues.

So there's a lot of things coming down the pipe and I don't think they're necessarily all priced into the market. And at that point when these things do occur and people start to pay attention to that and they don't see maybe earnings coming out as strong as they did in second quarter, then I think we'll have a little bit of a catalyst.

- So what are you doing to strategize with the portfolio ahead of that? How are you keeping portfolios defensive at the moment?

KATHY ENTWISTLE: Yeah, and actually I'm just starting to have those conversations with clients in the last couple of weeks and going forward. I really feel it's time to start making some changes into the portfolio in order to protect you know the, the money that's been made over the last year, over the last 10 years, for that matter. We've really had quite a run up in the equity markets, and a lot of clients I say you won the gain, we don't need to take the risk of losing these gains at this point. So maybe cycling into some other areas of the market that are a little bit more conservative, and also looking at the areas of the market that have a little bit more cyclical nature, cyclical nature and a little bit more defensive.

So that's you know, that's pretty much what we're doing right now with clients and having those conversations. And I would expect over the next four to six weeks we would you know be finishing that transition.

- Are you getting defensive with assets outside of US equities because we're seeing finally some activity over in the bond market? You know, when you look at it relative to the returns in the equity market it's nothing really to talk about, but we are seeing yields move higher now. Is there a place in the portfolio for a little bond market action?

KATHY ENTWISTLE: Yeah, we're starting to look at like very ultra short at the moment because if you think about it as interest rates rise, long term bonds are going to you know go down, it's an inverse relationship. So what we're trying to do is start with more near-term maturities in the bond market and then latter into longer maturities as interest rates continue to rise. So that's you know basically a defensive strategy from the fixed income side of the market. We certainly consider other areas of the market, real estate, alternative investing for clients, and of course on the equity side, we are continuing to focus on areas that we like such as financials, health care, staples, and also to be more selective within the different sectors of the economy because there should be some sort of a divergence there as well.

- What are you doing with, with technology, especially big tech, which we know we've been talking about for a long time now, valuations there have been lofty, but they have been coming down over the past couple of weeks?

KATHY ENTWISTLE: Yeah, you know when I look at some of my clients' portfolios, the tech part of the mark-- the market or the portfolio has certainly outperformed other areas. And if you take that disciplined approach and you do rebalancing with your clients year after year, you'll be able to pull back on some of the growth areas and listen if they continue to grow you still have exposure there, you've just reduced it a little bit, and you've taken that money and you've put it into other areas that maybe haven't performed as well over the last year such as value. And if we're right, then we should see some value do well going forward. And this is just a basic market tenet that we followed for many years with our clients and we'll continue to follow

- Kathy, you talked a moment ago about the market maybe not having priced in particular catalysts coming up. One of those catalysts is going to be the Federal Reserve, and when they finally start taking their foot off the accelerator and start to roll back those bond purchases. We know that a few policymakers came out today sort of making the argument that the economy is moving closer to a point where the Fed will be able to do that. If they do, do that sooner rather than later, do you believe this market has sufficiently priced that in?

KATHY ENTWISTLE: No, actually I don't think it's sufficiently priced in at all, and I do think that we will-- you know we've, we've really benefited over the last year plus of the market holding being held up by the Fed's moves and the way that they've supported the economy. And once they start to taper off there and we do believe it's time for them to start that process, it is going to be a little bit of a bump in the road for investors. And I would say they're sort of stepping away, they're sliding out of this right now, and we would expect them to be, to you know completely taper off by you know mid next year. So maybe another nine months from now, which is not that long when you think of it. And Yeah, so we'll see some changes in the market there.

And potentially, I guess the last time we focused on the Fed slowing down their purchases was back in 2013 2014. And equity markets client but the yields rose and gold prices sank. I don't necessarily think we'll see the same now in terms of equity prices rising because we're also going to have interest rates going up as well and some tax impacts and other impacts affecting the price of the stock with companies having to either you know increase prices or take on the cost of, of you know supply chain issues.

- Yeah, you're right. I mean, history can be a guide, but certainly the backdrop different today than it was back in 2013- 14. Kathy Entwistle, managing director at Morgan Stanley, always good to see.