Morgan Stanley's strategists recommend cutting risk, with equal weight across assets. For upside, look to Japan, energy, munis and mortgage-backed securities.
The current investment landscape is not unlike driving in torrential rain, during rush hour. As brake lights flash and exits back up, it’s impossible to know whether to stay the course, change lanes or just pull over and wait it out.
This is the predicament that investors face today in what Morgan Stanley’s economics team describes as “the most chaotic, hard-to-predict macroeconomic time in decades.” Their Midyear Economic Outlook takes the view that the global economy will bypass a recession in 2022—ending the year with 2.9% GDP growth—but caution that road ahead is rife with risk.
That’s certainly true for investors, says Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research. “So far, 2022 has not only seen a tragic conflict in Europe, but it’s also brought the worst bond market performance since 1980, the biggest commodity outperformance since data began in 1960, and large moves within and between equity indices,” he says.
Broadly speaking, he and his colleagues recommend staying defensive, diversified—and patient. “We continue to approach these dynamics through a ‘late-cycle’ lens,” he says, noting that rules-based strategies that systematically look for relative value across asset classes have done, and should continue to do, well.
Bottom line, Sheets says, stay light on overall exposure, with an equal-weight in global equities, bonds and spread products, including mortgage-backed securities. One bullish exception in is energy, which may hedge inflation with potential for upside.
Here are four key takeaways for investors:
1. U.S. Equities: More of the Same
Recent volatility in U.S. equities isn’t unfounded. Downward earnings revisions and a weaking Purchasing Managers' Index (PMI) suggest the bear market is not finished. “We see further de-rating and U.S. weakness,” says Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist. He and his team’s 12-month price target for the Standard & Poor’s 500 is 3,900—or below where it was in early May.
Morgan Stanley 2022 Midyear Economic Forecasts vs. Consensus
(May 2, 2022)
|2Q23 Forecast||2Q23 Return Forecast|
2. Europe Gets Worse Before It Gets Better
At first glance, European stocks are trading at attractive valuations. But, European strategists caution, prices may not yet reflect all the bad news.
In fact, while the index price-to-earnings ratio was recently in the low double digits, it has dipped into the single digits twice over the last 15 years. “And while MSCI Europe trades at a record-low relative valuation to the S&P, its relative valuation against MSCI ACWI ex US is actually above average,” says Graham Secker, Head of the European Equity Strategy Team.
Further, European economists have revised their GDP forecasts lower and their inflation estimates higher, and at a time when the European Central Bank is beginning to remove policy stimulus. “Against this backdrop, we think that the risk/reward profile for MSCI Europe remains unattractive,” Secker adds.
3. Japanese Equities Offer Upside
Unattractive risk/reward profiles are also a common theme through much of Asia, including China. However, Japanese equities continue to be a notable outlier. Valuations are low, return on equity is approaching a 40-year high, and earnings are boosted by Japanese yen weakness. Meanwhile, the macro-economic outlook is relatively positive. GDP growth, while modest at 1.9%, is an improvement over 2021; the country has low inflation and a central bank on hold. Under their base case, strategists see the TOPIX returning 9.3% over the next 12 months.
4. Strength in Oil, Munis and Mortgages
As we head into the second half of 2022, the strategists see a few asset classes that may provide upside:
- Commodities: Given supply shocks and war in Ukraine, it’s no surprise that commodities are on track to outperform equities for the second consecutive year—and energy commodities still have potential for upside, say strategists. Morgan Stanley’s energy team thinks brent oil prices will rise to $130 in the third quarter of this year.
- Municipal bonds: Munis present a solid risk/reward opportunity—thanks to durable credit quality and attractive valuations. They’ve recovered since their pandemic-level lows, and “given positive real GDP growth and an understanding that inflation is generally a neutral credit factor, these gains should be locked in through year-end,” says Global Director of Fixed Income Research Vishy Tirupattur.
- Mortgage-backed securities: With average 30-year fixed-rate loans having recently reached their highest levels since 2009, now may not be a great time to shop for a mortgage. Residential mortgage-backed securities (RMBS), on the other hand, are attractive, particularly relative to corporate credit. “In looking out over the next 12 months, non-agency RMBS is our preferred asset class across securitized credit,” says Jay Bacow, co-head of U.S. Securitized Products Research.
For more Morgan Stanley Research on Global Strategy, ask your Morgan Stanley representative or Financial Advisor for the full report, “Global Strategy Mid-Year Outlook: The Tempest" (May 10, 2022). Plus, more Ideas from Morgan Stanley's thought leaders.