Morgan Stanley
Wealth Management

3 Risks in an Unfamiliar Market

Dec 13, 2023

Investors are navigating strange terrain with a surprisingly resilient economy, a top-heavy stock market and a deeply indebted government. Here’s how to stay on course.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • The economy has been surprisingly resilient to rising interest rates, suggesting that falling rates may do little to stimulate growth.
  • Lower rates may also fail to deliver the anticipated boost to the market’s biggest stocks, leaving passive index investors disappointed.
  • The swelling federal debt, at nearly 125% of GDP, could threaten economic growth and boost inflation.
  • Investors should temper their 2024 expectations and focus on yield, cash flow, value-oriented investments and tax-efficient portfolio strategies.

What are some of the most dangerous words in financial advice? “This time is different.” Investors often invoke the phrase when they’re optimistic about a favorable outcome and hope market dynamics will somehow defy the historical norm. But they rarely do.

 

Morgan Stanley’s Global Investment Committee continues to suggest caution in today’s richly valued equity market. That said, we do see a few things that are, in fact, markedly different from history—just not for the reasons many investors might hope.

  1. 1
    The economy appears much less sensitive than expected to rising interest rates.

    The Federal Reserve has rapidly raised rates by more than 5 percentage points since March 2022. While economists might reasonably expect those rate hikes to tighten financial conditions and dampen growth, U.S. households and businesses alike have been surprisingly resilient, thanks in part to the trillions of dollars in fiscal stimulus distributed during the pandemic, as well as the very low borrowing rates locked in from the prior decade. The risk here is that “rate insensitivity” could cut both ways—meaning, if rising rates have been of little detriment to the economy thus far, falling rates could prove equally ineffective in stimulating growth. This could reduce company earnings and stock valuations going forward, as lower interest rates appear to be already priced in.

  2. 2
    The overall market capitalization of the S&P 500 Index is extremely concentrated in a handful of companies known as the “Magnificent 7.”

    Not only have those biggest stocks accounted for much of the index’s overall gains this year, but the difference in valuation between them and the other 493 stocks is striking. The Magnificent 7 are, on average, more than twice as expensive as the others, with a forward price-earnings ratio of about 33. Given their already extreme valuations, falling rates aren’t certain to help boost the prices of those mega-cap names much further. Rather, the beneficiaries of lower rates may be in “cyclical” sectors such as financials, consumer discretionary and industrials, where valuations look more reasonable today and may have more room to rise. Considering how the mega-cap stocks dominate the S&P 500, their potentially limited additional gains could jeopardize the continued strength of the index. Investors who are banking on that may be disappointed and could miss out on potential returns in other corners of the market.

  3. 3
    The U.S. federal debt has grown almost unmanageably large.

    At $33 trillion, it represents about 125% of annual GDP. What's more, annual deficits are expected to continue for the next decade. This could hinder economic growth: Excessive federal debt tends to put upward pressure on interest rates, making it more expensive for U.S. households, companies and the government to borrow. That, in turn, may dampen spending and investment across the public and private sectors. In addition, government money-printing to cover mounting borrowing expenses may lead to a fresh surge in inflation.

So, while things appear, in some ways, to be different this time, such a unique investing environment brings its own set of risks, with very little historical precedence to act as a guide. Investors should keep expectations for 2024 gains muted.

 

As for portfolio strategies, investors should look for yield and cash-flow opportunities, as well as value-oriented investments in financials, U.S. small- and mid-cap stocks, and international equities.

 

Finally, as the year comes to a close, consider using tax-smart strategies to mitigate the drag that taxes can have on your portfolio.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from December 11, 2023, “How It Could Be Different This Time.” 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.

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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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