Morgan Stanley
  • Wealth Management
  • Feb 20, 2018

Getting More Defensive

The long-lived bull market isn’t over yet, but this may be the beginning of the end. Here’s why.

The correction in stock prices earlier this month has been misleading in some ways. In size, it was perfectly normal as the S&P 500 declined a little more than 10%. It has been followed by gains and the market is now up year to date. I think there is room for stocks to rise more as earnings and economic growth remain robust and stock valuations are more attractive. Recession warning signs are not flashing.

However, when I consider how stocks, bonds and the dollar are trading in relation to each other, I see a more subtle shift in markets occurring. I don’t think we are at the end of the bull market, but we may be at the beginning of the end.

Here’s why: Most corrections in stocks are accompanied by a rise in bond prices (and a decline in yields) as investors take risk off the table and seek greater safety. That hasn’t happened this time around. In fact, bond prices have fallen (and yields risen) and the dollar is weaker. Higher interest rates, falling stock prices and a weak dollar represent a tightening of financial conditions—which have been very easy for a long time, a key source of fuel for the long bull market.

Higher interest rates aren’t purely a result of rising inflation expectations. Growth may in fact be running too hot, turbocharged by tax cuts and deficit spending, including a potential infrastructure push. Surging deficits will likely require greater Treasury issuance, which will lead to higher rates, even if inflation doesn’t rise much more.  As interest rates rise, companies face a higher cost of capital, which ultimately slows growth.

We aren’t there yet. I think stocks will continue to do well, but markets will remain volatile and the market-leading sectors may shift. I recommend investors gradually start to get more defensive. Adding yield-oriented equities, like utilities, could make sense. While long-term investors facing an ordinary correction would not normally be advised to change their asset allocation mix, financial conditions suggest even long-term investors should be re-examining their mix.

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