Many pundits are bullish on stocks, but there’s evidence that investors need to prepare for a less rosy scenario.
After recently tumbling into “correction” territory, U.S. equities staged a strong rebound last week. The S&P 500 Index advanced 5.9%, its best weekly performance of the year, accompanied by a pullback in bond yields as the 10-year Treasury yield fell 26 basis points to 4.57%. Investors, it seems, may be looking forward to continued gains from here on, hoping to end the year with a “Santa Claus rally.”
But what’s behind this latest bounce-back in stocks? It looks like the market zeroed in on the fact that the Federal Reserve left interest rates unchanged in its November meeting, keeping the target federal funds rate between 5.25% and 5.50%. With that, pundits and bullish investors were quick to return to the narrative that the rate-hiking cycle is now over, the inflation fight is won and growth in corporate profits lies ahead. Illustrating this point: The futures market is again pricing a whole percentage point of rate cuts in 2024.
Morgan Stanley’s Global Investment Committee, however, is less convinced. Certainly, we respect that the market, which represents the “wisdom of crowds,” has a good track record of projecting future reality over the long term. But in the short term, there’s still a lot of noise.
We believe it’s important to base our market analysis not just on moves at the aggregate index level, but on what we find beneath the surface and across asset classes. This approach continues to support our cautionary stance, in light of four observations.
1. Potential slowing in economic growth:
Despite blowout readings for third-quarter GDP, other data suggest a softening in economic activity. The Conference Board’s Leading Economic Index fell by a worse-than-expected 0.7% in September, marking its 18th straight month of declines. Manufacturing weakened sharply in October, according to the Institute for Supply Management’s index, and last week’s nonfarm payrolls report revealed a weaker-than-expected 150,000 new jobs in October and an uptick in the unemployment rate to 3.9%.
2. A specter of “sticky” inflation:
There’s been little improvement in certain key components of inflation, including wages and housing. The Employment Cost Index accelerated in the third quarter, rising 1.1%, while October jobs data showed wage gains are still running at a higher-than-expected 4.1% year-over-year. Housing prices gained further momentum, gaining an annualized 2.6% in August, according to the latest data from the CoreLogic S&P Case-Shiller Index.
3. A “sideways” stock market:
Even with recent gains in equities, the overall direction in stock prices remains uninspiring. Market breadth and volumes remain weak, with the median stock having essentially gone nowhere since last May. Meanwhile, cyclical sectors such as consumer discretionary have underperformed their defensive counterparts such as utilities. Gold’s continued outperformance also suggests that we are still in a bear market.
4. Cracks in credit:
Lastly, stresses are emerging in the weakest parts of high-yield, or “speculative grade,” credit. Data show a growing number of bankruptcy filings and weaker financing availability for small and medium-sized businesses, indicating the lagged effects of policy tightening may now be surfacing more visibly.
Given today’s risks and uncertainties, the Federal Reserve seems to be willing to take a wait-and-see approach, and we believe investors should do so as well.
While exercising patience, investors may consider using market volatility to execute tax-management strategies and rebalance portfolios toward investments that offer strong yields. Investors may also look at stocks with quality cash flows that are fairly priced based on achievable earnings targets. “Defensives” such as utilities and staples could provide ballast, and value-oriented opportunities are emerging among financials, U.S. small- and mid-cap stocks, and international equities.
