As U.S. equities struggle to break out of a bear market, opportunities abound in fixed income.
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Investors searching for good news have certainly found some: The latest consumer price index report suggested inflation may have peaked in October, and the Federal Reserve is perhaps now more likely to slow the pace of interest rate hikes. There was more reason for optimism last week, with investor sentiment, measured by the American Association of Individual Investors, at its highest levels since December 2021.
However, while this may be the beginning of the end of the U.S. equity bear market, do not mistake it for the actual end. Investors still need to allow this prolonged market downturn to fully play out and make a realistic assessment of the economic slowdown and risks of recession.
Historically, when investors’ primary concern shifts from policy and inflation to the health of the economy, the outlook for stocks and bonds often diverges. That’s why investors may be relatively well served by favoring bonds over stocks in 2023. Here’s the evidence:
- Bond yields have meaningfully increased, providing investors an opportunity to earn decent income. We expect inflation to be around 3.5% by the end of 2023, and U.S. Treasuries, through the 10-year maturity, are yielding more than that. That means their inflation-adjusted, or “real,” yield could turn positive. Meanwhile, municipal and corporate bonds are providing an extra 1.5 to 2.5 percentage points beyond Treasury yields.
- Bonds are also relatively fairly priced. Tightening cycles, in which the Fed raises rates to bring down inflation, generally do not end before the Fed funds rate is durably above core inflation, suggesting that bond prices have fully adjusted. Once this adjustment is complete, bonds may be viewed as fairly priced. Currently, the futures market for the Fed funds rate is predicting a peak of about 5%, to be reached in April or May. This appropriately coincides with where core inflation is likely to be.
- Bonds may offer attractive capital gains. Investors who are wary about the economy will likely gravitate toward Treasuries, which would push yields lower and prices higher, meaning it’s possible to enjoy relatively high coupon payments now and potentially sell at a premium later.
In contrast, U.S. large-cap stocks, as measured by the S&P 500 Index, do not look as attractive:
- They are still too expensive. At current prices and consensus earnings estimates, the S&P 500 Index is selling at a forward price-earnings (P/E) ratio of 17. This is not compatible with where rates and inflation are likely to be next year—risk-free long-term rates around 3.5% and inflation above 3%—alongside lackluster economic growth. A more reasonable forward P/E ratio under these conditions is typically in the 15-to-16 range.
- The reward for owning stocks over risk-free debt appears relatively small. Compared with Treasuries, stocks are priced to offer just about 180 basis points (or 1.8 percentage points) more, a huge disconnect from the prior decade’s average spread of 350 basis points.
- Wall Street’s 2023 outlook for U.S. stocks looks concerningly unrealistic. Equity analysts currently project that S&P 500 company earnings will be $230 per share next year. Morgan Stanley expects $195, based on our belief that companies’ extraordinary ability to boost sales and profitability in recent years is unsustainable and may soon reverse.
We continue to believe it is premature to call an end to the bear market for U.S. stocks. Investors may have moved on from inflation concerns, but they cannot ignore the economic picture. For now, investors should consider reducing U.S. large-cap index exposure. Instead, look to Treasuries, munis and investment-grade corporate credit. Stay patient and collect coupon income.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from November 21, 2022, “Bonds Over Stocks in 2023.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.