Morgan Stanley
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3 Signals of Equity Market Trouble

Feb 22, 2023

Will economic growth today simply postpone a “hard landing”?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Some investors believe economic growth can remain robust or even re-accelerate.
  • However, resurgent growth would likely spur the Federal Reserve to keep interest rates higher for longer.
  • Higher interest rates would pressure stock valuations, making defensive stocks a potentially prudent choice.

Wall Street has speculated for months about whether the Federal Reserve’s aggressive efforts to tame inflation would drive the U.S. economy into a hard landing or a soft one. Investors are now floating a new theory: “no landing.” It’s the latest iteration of a bullish narrative underlying the stock market’s notable recovery from last year’ lows.

 

The thinking goes something like this: Instead of an outright recession or a gentle economic slowdown, growth can remain robust—or even re-accelerate—and companies can achieve their earnings estimates. Proponents of this view cite recent data showing continued momentum in consumer spending and a strong labor market.

 

As regular readers may know, Morgan Stanley’s Global Investment Committee is skeptical of this perspective. Economic resilience doesn’t occur in a vacuum; it usually comes with resilient inflation. That may lead to a stronger policy response from the Fed and higher interest rates, which could ultimately curb further economic growth and weigh on asset prices—a possibility equity investors seem to be shrugging off.

 

Consider the following three developments that indicate there’s more risk than recent stock gains may imply: 

  1. 1
    Asset classes other than equities are factoring in strong economic data and preparing for higher rates.

    Bond yields have moved up significantly, with the 10-year Treasury yield hitting 3.8%, and the policy-sensitive 2-year yield reaching 4.6%, its highest since November. What’s more, over the past two weeks, the U.S. dollar has strengthened 3%, while West Texas crude oil prices rose about $3 per barrel. These moves suggest that equity investors are ignoring fundamental data that is having an impact on other assets, and may be caught off guard when higher rates eventually weigh on stock valuations.

  2. 2
    Market-based inflation expectations have moved up.

    The 2-year breakeven rate—reflecting the market’s estimate of inflation in the next two years—has risen to 2.9%, well above the Fed’s inflation target of 2%. Perhaps more importantly, traders have amped up their expectations for the terminal rate, or how high the Fed will take the Fed Funds rate this hiking cycle, to beyond 5%, up from early February’s market-based forecasts of around 4.75%. 

  3. 3
    Consumer and producer prices are no longer declining with speed.

    Recent consumer prices data showed month-over-month gains of 0.5%, the largest move in three months. Compared with a year earlier, inflation has slowed to 6.4% but missed expectations for 6.2%. The wholesale side substantiates the trend, with producer prices rising 0.7% in January, also stronger than expected. 

These three factors have yet to change the bullish mood in stocks. Any recent attempts at market repricing have been met with investors attempting to “buy the dip,” therefore driving stock prices back up. Continued resilience in consumption tends to mean persistent price pressures. This, in turn, means policymakers are likely to keep interest rates higher for longer, ultimately pressuring stock valuations. In a sense, the “no landing” theory may simply be a “hard landing” that is being postponed.

 

Investors should consider opportunistically adding defensive stocks that have recently sold off, with a focus on dividend and cash-flow yields, as well as earnings achievability.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from February 21, 2023, “Don’t Bet on ‘No Landing.’” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

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

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

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. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

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.

Disclosures

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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CRC#5475589  (02/2023)

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