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3 Pockets of Economic Stress to Watch

Mar 26, 2024

Growing consumer debt, falling business sentiment and rising loan delinquencies in commercial real estate could sap the economy’s momentum. How can investors prepare?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • The U.S. economy has shown resilience to the Fed’s rapid rate hikes, but there are signs of potential stress.
  • Consumers could experience higher interest costs on their growing non-mortgage debt, particularly credit cards.
  • The prospect of higher-for-longer rates is also weighing on business sentiment and already-vulnerable sectors like commercial real estate.
  • Investors should consider reducing exposure to consumer discretionary stocks, favoring industrial cyclicals, capital-market-leveraged financials and defensives. 

Tempered expectations of the Federal Reserve’s plans to cut interest rates don’t seem to be slowing down equities, where economic strength in the U.S. has helped push stocks to all-time highs.

 

While many investors appear to be shrugging off the possibility of higher-for-longer rates—and the potential drag on growth—Morgan Stanley’s Global Investment Committee thinks the insensitivity to higher rates isn’t sustainable or realistic for every corner of the economy. Here are the areas where we see accumulating signs of potential stress: 

  1. 1
    Consumers:

    While spending on services and, more recently, housing remains robust, goods consumption has begun to weaken, as revealed by disappointing data on core retail sales (which excludes sales of automobiles, gasoline, building materials and food services). In particular, consumers, especially those in lower-income households, may be starting to feel the bite of higher interest expenses on their growing pile of debt aside from their mortgages. Aggregate credit card balances now total $1.1 trillion, up more than 45% from pre-COVID levels. And with a median credit card interest rate above 20%, the median household is left paying as much in credit card interest payments as their mortgage interest payments. Higher-for-longer rates certainly won’t help.

  2. 2
    Small businesses:

    The prospect of higher-for-longer rates doesn’t seem to be helping sentiment among small-business owners either. The sentiment index of the latest National Federation of Independent Business survey fell to 89.4 in February, its 26th consecutive month below its 50-year average of 98. Business owners reported a diminished appetite for hiring and capital investments, while concerns remain around profits and the difficulty of obtaining credit. Survey respondents also indicated low intentions for raising employee wages and a greater likelihood of price increases to hold margins.

  3. 3
    Commercial real estate and regional banks:

    Persistent high interest rates are also likely bad news for already-vulnerable sectors that have been operating on short-term financing, such as commercial real estate. Owners in this sector have been getting by thanks to the liquidity provided by shadow banking and private lenders. But over the past year, office-space values have fallen by more than 35%, and Morgan Stanley Research has suggested additional downside of as much as 10%. It’s also notable that regional banks own 60% to 80% of related loans that are coming due in two to three years. With delinquency rates rising, commercial mortgage-backed securities may be among the first areas where this stress becomes visible. 

What Does It Mean for Investor Portfolios?

Stock-market prices and valuations continue to look disconnected from the fundamentals of rates, inflation, earnings-forecast revisions and any gaps between actual and projected economic data. This backdrop suggests the possibility of “stagflation”—slower growth with sticky inflation. We remain focused on finding investments with justifiable valuations and diversification in portfolio construction.

 

Investors should pay attention to data around consumer confidence, labor markets and credit card delinquencies. And consider reducing exposure to consumer discretionary-oriented stocks in favor of a mix of:

 

  • industrial cyclicals, in such sectors as materials, energy and infrastructure
  • capital-market-leveraged financials
  • defensives like utilities and real estate investments trusts (REITs)

 

We recommend investors shift more of their portfolio toward intermediate-duration fixed income, as well as credit and equity-leveraged hedge funds.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 25, 2024, “The Haves and Have-Nots.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

 

Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates.  Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Hedge funds may involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager.Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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