Morgan Stanley: Why Equity Markets Remain Vulnerable

    Investors may be making flawed assumptions about the path of inflation, monetary policy and corporate earnings. What that could mean for markets going forward.

    Morgan Stanley: Why Equity Markets Remain Vulnerable

    The stock market is a curious thing. Yes, there have been the ups and downs of the daily churn, driven by news and company-specific earnings results. But equities have been holding up relatively well considering the broader context: decades-high inflation and the most radical pivot toward tighter U.S. monetary policy since 1994. This has produced the worst rout in U.S. Treasuries in 50 years and sent short- and long-term yields surging. Given all this, one might expect stocks to be in worse shape.

    Why aren’t they? It’s possible that equity investors are banking on certain assumptions, which we think are ultimately flawed. Let’s examine three:

    Assumption 1:

    Inflation will soon start to cool and thus the Federal Reserve won’t actually raise interest rates and unwind its massive balance sheet as aggressively as once thought, which would limit the hit to equity valuations.

    Our Take: The latest consumer price index report did have some elements to suggest inflation may be topping out: Goods-related inflation appeared to ease, and “core” inflation, which excludes energy and food, came in better than expected. But we shouldn’t write off the potential for persistent inflation. Rents are still growing, and inflation in services businesses, especially linked to travel, is significant. Also, the intensification of the Russia-Ukraine conflict leaves little room for relief in rising energy, metals and food prices, while the renewed COVID-related shutdowns in China are re-igniting supply chain-related price squeezes.

    Assumption 2

    Earnings growth will continue to be strong, with businesses insulated from inflation and higher rates.

    Our Take: Nearly 80% of the companies that have reported first-quarter earnings so far have beaten estimates, so there has been reason for some optimism. But we believe earnings pressures continue to grow and current profit-margin expectations may be overly optimistic. Costs continue to rise, and inventories are now outpacing new orders. The inflationary environment may be eroding consumer purchasing power, particularly for lower-income households. The strength of the U.S. dollar also creates headwinds for exporters and pressures the value of the income earned from international markets.

    Assumption 3

    U.S. stocks must be the best place to invest relative to bonds and international markets.

    Our Take: U.S. equities, especially big tech stocks, have indeed been a winning asset class over the past 12 years or so. But that doesn’t mean they will always be. Valuations are rich today at a time when growth is decelerating and policy is tightening. Markets elsewhere may provide more attractive relative value. In regions such as China, equities trade at trough valuations against recessionary conditions. As for emerging markets, headwinds from commodities inflation may ease, while expectations are modest and currencies may strengthen as well. In Europe, a more dovish central bank, combined with possibly more coherent fiscal policy responses in the wake of the military conflict, could support a recovery. 

    Today’s economic fundamentals are different from the prior cycle’s, and investor portfolios should change, too. Investors should consider diversifying by asset class, region, sector, style and market capitalization. Use stock market rallies to take profits in passive indices and redeploy toward active management. If you’re currently underweight in cash and bonds, try to neutralize those allocations with an eye toward Treasuries, which are now trading closer to near-term fair value.



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