There’s something to be said for looking on the bright side, but many investors are currently clinging to a dangerous narrative. They assume that weak economic growth—which could spur the Fed to ease its rate hikes—is reason to be optimistic about the outlook for U.S. stocks and other developed equity markets.
Morgan Stanley’s view is decidedly different. In the past, a sharp slowing of a previously strong economy has repeatedly been poor for stocks, particularly in relation to high-grade bonds. Warning signs of stock market risk abound: an inverted yield curves, falling earnings expectations, high inflation, tight labor markets, weak commodity prices and tightening standards for bank lending. Historically, the combination of any of these factors has pointed to a poor environment for global equities versus bonds. Today, however, all these warning signs are flashing, a highly unusual confluence.
As a result, we expect a sharp deceleration in both U.S. and European growth this year, which puts earnings at risk. Our forecast for earnings per share on both sides of the Atlantic is below the consensus.
What would change our mind? We think the bull case for equity markets is simple: better-than-expected growth, even if this means higher interest rates. Here’s why:
Last year was the first in 150 years that both U.S. stocks and long-term bonds fell more than 10%. The starting point for valuations in both equity and fixed income is now better, leaving more room to absorb higher rates.
Throughout 2022, higher interest rates drove equity declines. But recently, that’s been shifting, and over the last 60 days, stocks and bond yields now seem more likely to fall together. This pattern is more consistent with growth becoming a more dominant concern of markets.
Fed policy easing isn’t necessarily good for markets, and we think the historical evidence proves it. In August 1989, January 2001, September 2007 and February 2022, the Fed easing monetary policy as growth weakened. All were very bad times to sell high-grade bonds and buy equities.
The level of easing is also key. U.S. markets are now priced for the Fed to cut rates by approximately 160 basis points over the next two years. Since 1980, there have been six Fed easing cycles of 150 basis points or more; five of those were associated with recessions.
Bottom line: Investors should be careful about wishing for weaker growth, even if it prompts the Fed to ease up on rates. Right now, we think the risk/reward equation is poor for global equities relative to high grade-bonds. Asia (except Japan) is the one region where we see strong and accelerating growth this year.
