While 2020 has certainly been exceptional, Morgan Stanley strategists believe a new cycle has started—and a recovery could be more “normal” than investors expect.
To date, 2020 has been anything but normal. COVID-19 has created a global health crisis, upended trade, halted travel and confined much of the world's population to their homes. Now, the reopening of economies raises new questions about what constitutes the “new normal."
“Add to that a U.S. election season, simmering global trade tensions, swings in commodity markets and social unrest, and it would seem reasonable to throw up one's hands and say that the old rules or framework no longer apply," says Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist. “We disagree."
While the past four months have been exceptional, Sheets and his strategy colleagues believe a new cycle has started—and despite the historic circumstances, a recovery may be more “normal” than investors expect.
This outlook is consistent with Morgan Stanley's macroeconomic forecast for a V-shaped recovery, in which global gross domestic product turns positive in early 2021 and grows 3% for the year.
Morgan Stanley economists expect a much faster recovery than during the 2008 Global Financial Crisis
(Global Real GDP; Pre-crisis level=100)
In light of this view, Morgan Stanley strategists have increased their base-case equity targets across the board with a forecast of 12% upside for the S&P 500 through June 2021, and 10% returns for the MSCI Europe. In Japan, the Topix could decline just 2% over the next 12 months, while the MSCI Emerging Markets index is now forecast to decline 7% vs. 19% previously.
Stocks and credit markets as a whole could move modestly higher and tighter over the next 12 months, Sheets forecasts, but the more compelling opportunity may lie in traditional early-cycle rotations: small-capitalization and cyclical U.S. stocks; value stocks in other developed markets; plus higher yields, steeper curves, a weaker dollar and lower levels of volatility.
While Sheets notes that Morgan Stanley forecasts have taken into account a summer surge in U.S. coronavirus cases, given the unpredictability of the pandemic and the effect on consumer market psychology, the path of coronavirus infections will remain a risk-factor to any outlook.
Morgan Stanley strategists see the most V-shaped profile for U.S. earnings, with Europe ranking second, driven by fiscal support and relatively high exposure to cyclicals
Embrace Cyclicality in U.S. Assets
In their macro outlook, Morgan Stanley economists note that the U.S. economy troughed in April, began recovering in May and has gained momentum in June. This marks the shortest U.S. recession on record, dating back to the 1920s.
U.S. equity markets, meanwhile, are in the early stages of a new cycle and bull market, says Mike Wilson, Chief U.S. Equity Strategist and Chief Investment Officer. The market's correction in early June was overdue and will likely bring more downside, he adds, but it looks healthy and may offer a buying opportunity.
The recent outlook isn't due to dramatic changes in earnings-per-share expectations. Rather, the updated equity returns reflect improvements in target price-to-earnings (P/E) multiples and another six months of a strong earnings recovery. “High multiples on trough earnings is fairly common," says Wilson, whose team expects earnings to rebound 20% in 2021.
That said, the biggest gains will likely come for smaller companies and more cyclical names. “Recessions and large economic shocks tend to bring about a rotation in style and macroeconomic factors and we think this time is no different," Wilson adds. “Investors initially seek the safety of more defensive equities, but as the economy recovers, they shift into more cyclical pockets of the market."
At the sector level, the U.S. strategy team is overweight financials, industrials, materials and health care; they're underweight technology, staples and utilities.
Value and Small Cap tend to outperform in recoveries,
while Low Vol is usually punished the most
(Avg. performance of equity factors in post-recession recoveries, 1990-2010)
Some Notable Exceptions
Looking beyond U.S. equities, Morgan Stanley’s strategists are relatively upbeat about European stocks, particularly among value names. Their midyear playbook for the region recommends overweighting financials, materials and utilities; it calls for lighter allocations to staples, energy and luxury stocks.
Emerging-market equities, however, are a notable exception. While they were early-cycle winners following the past two recessions, “we think that this time could be different, with corporate profitability in emerging markets more severely impaired," says Sheets. The same is true of commodities, such as oil, aluminum and iron ore, which have traditionally been early-cycle winners but could trail this time around, given supply and/or demand challenges.
In fixed income, credit investors may do better to focus on the middle of the ratings spectrum in high-yield and securitized debt, rather than the hardest-hit credits. Select higher-yielding emerging markets, meanwhile, could see significant tightening.
Strategists are less bullish on government bonds: In the U.S., they expect yields to move higher, with 10-year Treasuries ending 2021 at 1.5%, due to fast economic recovery, strong performance in risk assets and expectations for even more supply.
Reasons to Trust, But Verify
Investors should note that this cycle could be more normal than they might have expected, but they also need to verify that trade, policy and the pandemic don't knock these conditions off course. Although new COVID-19 cases are surging in the U.S., it appears that the rate of fatalities have fallen. Health systems also seem better equipped to deal with new infections than during the first wave.
U.S. elections and trade tensions could also disrupt the early-cycle trajectory. Historically, U.S. stocks have seen below-average returns in the three months ahead of competitive presidential elections. Interestingly, both presidential candidates may have similar views on U.S.-China trade tensions; that raises related risks, as the election approaches.
Fiscal policy is another wildcard. Morgan Stanley's base-case scenario assumes that the U.S. will roll out an additional $1 trillion in stimulus this summer, and that the European Union will agree on a €750 billion recovery fund. “The failure or dilution of either and, more broadly, a premature shift back toward belt-tightening would be a major risk," says Sheets.
For more Morgan Stanley Research on Global Strategy, ask your Morgan Stanley representative or Financial Advisor for the full report, "Trust, But Verify" (June 14, 2020). Plus, more Ideas from Morgan Stanley's thought leaders.