Why Investors Shouldn’t Worry About Slowing Growth

These days, we are seeing some of the classic indicators of a transition into the middle phase of an economic cycle: Year-over-year comparisons of growth measures and corporate earnings are cresting. So, too, are economic surprises, or the rate at which data is beating forecasts. 

As economic growth moderates, uncertainty has risen and a “growth scare” narrative has begun to take hold among some investors. The market’s rotation toward defensive and secular technology stocks indicates that investors’ outlook on economic growth is dimming. There also seems to be worry that the Federal Reserve might start to taper its stimulative asset purchases earlier than expected, a concern seen in the U.S. Treasury market as the gap between short- and long-term yields narrows. Some pundits are even warning of a return to 1970s-style stagflation, a difficult period of high inflation and slow growth.

These may be popular market sentiments, but we remain convinced that a growth scare is overblown. Here are three reasons why:

• Although economic growth is slowing from the extreme comparisons of last year’s trough, it remains solid. Recently, preliminary estimates for second-quarter gross domestic product (GDP) growth came in at 6.5%. And Ellen Zentner, Morgan Stanley’s chief U.S. economist, forecasts third-quarter annualized GDP growth at 6.1%, expecting that supply-chain pressures will continue to resolve and fiscal spending prospects will turn up. Strong fundamentals also underpin this forecast: Recent data updates saw U.S. manufacturing activity grow, housing prices rebound and durable goods orders advance.

• Second-quarter corporate earnings have been excellent so far. As of July 30, with 59% of S&P 500 companies having reported results, 88% of them have reported earnings that came in above analysts’ expectations, and 88% have reported a positive revenue surprise. Looking ahead, analysts are projecting double-digit earnings growth for the remaining two quarters of 2021.

• The consumer remains strong. U.S. consumer confidence as measured by the Conference Board Consumer Confidence Index inched up slightly in July, to 129.1, the highest since February 2020. Stable confidence and rising wages, together with growing household wealth and ample savings, should keep consumer spending strong.

Still, the economy and markets face headwinds. Uncertainties remain around the Delta coronavirus variant. While we think the virus’ impact on corporate profits or intermediate-term economic growth will likely be limited, it could weigh more heavily on the labor market recovery, thus affecting Fed policy choices. With the central bank emphasizing its goal of “maximum employment” and sticking to its view that inflation will be transitory, we believe the risks of a policy error continue to build.

Another risk relates to developments in China, which recently signaled an intent to improve stability in its domestic financial markets and establish self-reliance in high-tech industries, making clear it plans to grow on its own terms, not those of the West. Longer term, this pivot may weigh heaviest on multinationals and U.S. secular growth companies that have long depended on globalization generally and China specifically for their growth.

Any transition into the mid-cycle phase is likely to come with uncertainty and volatility, and the extreme levels of liquidity searching for a home in today’s markets only complicate that picture. This means trading based on day-to-day developments is particularly risky. We recommend a measured and balanced approach to active stock-picking. Investors could consider taking profits from S&P 500 index funds and long-duration assets, and redeploying them into companies with quality cash flows, potential to beat forward earnings estimates and good stock valuation support. Likely candidates are in the financials, industrials, energy and healthcare sectors.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 2, 2021, "Everything and Nothing at All." Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.