Investors hoping for a new bull market are likely to be disappointed if financial conditions tighten in the coming months.
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Have stocks turned the corner? The S&P 500 Index has risen more than 13% since its mid-October 2022 low, and it’s up about 6% since 2023 started. For equity-market bulls, the rally reflects optimism that the Federal Reserve will prevail in its efforts to tame inflation and cut interest rates as it guides the economy toward a “soft landing” that supports corporate profitability.
Morgan Stanley’s Global Investment Committee is less optimistic. First, the path of inflation and pace of monetary tightening are still far from certain. More pointedly, the stock market rally may have more to do with rapidly easing financial conditions such as lower oil prices and higher consumer spending.
Generally, when investor sentiment is improving and market liquidity is increasing alongside loosening conditions, asset prices tend to rise. The opposite dynamic was at play for much of 2022 as the Fed rapidly tightened monetary policy. However, several factors recently have caused an aggressive loosening of conditions, back to levels seen in spring 2022. The problem: Those factors appear temporary and subject to major reversals in 2023. We think particular caution is warranted around four recent trends:
- A significant decline in oil prices. The West Texas Intermediate crude oil benchmark is down 35% since its highs reached in June 2022. While this has helped ease financial conditions, we think the decline may be an overshoot. Global demand could pick up materially with an economic recovery in China and other emerging markets, as well as in Europe.
- A drop in longer-term Treasury yields. The 10-year benchmark yield has dropped from 4.2% last fall to around 3.5% today, due to lower expectations for both inflation and the degree to which the Fed tightens policy to tame it. Lower yields typically mean lower borrowing costs across an economy, making it easier for businesses and consumers to spend. Yet, today’s market-based forecasts may underestimate where rates could end up, especially since current loose financial conditions—not to mention any possible stalling in inflation’s decline—could actually prompt the Fed to keep rates higher for longer.
- The U.S. Treasury running down its general account. As has been widely reported, the U.S. government is running up against the statutory debt ceiling, which prohibits further borrowing or bond issuance by the Treasury without congressional approval. The Treasury has been limiting how much additional debt it takes on and spending down its general account reserves. But once a debt ceiling resolution is passed, new bond issuance could drain up to $750 billion in liquidity from bond markets.
- Consumers spending down their excess savings. We estimate about $1.6 trillion of the $2.5 trillion in COVID-related stimulus savings has been spent. By November 2022, the consumer savings rate had reached a 17-year low of 2.4%. This year, as fears of a recession and job security mount, we could see U.S. consumers begin to normalize their spending behavior and return the savings rate to the long-term average of 6.5%. This could drain another $750 billion or so from the U.S. financial system.
Given these trends, and as tempting as it might be, investors should not interpret the January rebound in stocks as the beginning of a new bull market. Economic fundamentals have not troughed, and earnings estimates have not recalibrated to reflect the reality of a slowdown. The four trends noted above have combined to create a rare setup for easy financial conditions, and we have reason to believe they will reverse, causing a mid-year liquidity crunch.
Rather than chasing a rally built singularly on financial conditions, investors should focus on income generation as they wait for this period of high uncertainty to play out. Look to short- and intermediate-term Treasuries, municipal bonds and investment-grade corporate bonds, as well as dividend-growth stocks that offer above-average yields and decent earnings achievability even in an economic downturn.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from January 30, 2023, “A Coming Liquidity Squeeze.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
