Morgan Stanley
  • Wealth Management
  • May 25, 2021

Market’s Resilience Belies Looming Risks

Despite sharp pullbacks in some corners of the market, most U.S. stock indexes remain near all-time highs. Here’s why investors shouldn’t be lulled into complacency.

Nearly halfway into 2021, investors have endured a series of pullbacks in different asset classes and sectors. A recent rise in yields, for example, has driven 10-year Treasury prices sharply lower, year to date. Large technology and tech-enabled growth stocks are off 12% from their February all-time high, as measured by the NYSE FANG+ Index. And formerly red-hot special purpose acquisition companies, or SPACs, are down 23.3% from their recent peak, as measured by the IPOX SPAC index. Once high-flying cryptocurrencies have taken a beating, too.

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Yet, in the wake of these “rolling corrections” for specific assets and sectors, broader stock indexes appear resilient. The S&P 500 is down only 1.7% from its all-time high, and the Nasdaq 100 is still up 4.4% on the year.

With that in mind, it’s hard to blame some investors for thinking they may be in the clear and that broad indexes will simply continue to rise. After all, the recent pullbacks have been concentrated in some of the priciest corners of the investment world, and many investors may reason that the reversals have helped reduce market froth to the point that risks are now comfortably priced in.

We disagree. In fact, with multiple risks looming, as we shift from the early to middle stage of the business cycle, it’s as important as ever for investors to guard against complacency. Below are some of the key risks to keep in mind:

  • Higher inflation and interest rates: April’s Consumer Price Index (CPI) and Producer Price Index (PPI) readings came in much higher than projections, with several “core” CPI inputs concerningly high. While aspects of recent inflation are likely transitory, a number of secular shifts now underway suggest that higher prices could persist. In addition to boosting corporate borrowing costs, higher interest rates, which often accompany inflation, may hamper equity valuations.
  • A decline in positive economic surprises: The Citi U.S. Economic Surprise Index, which measures data surprises relative to market expectations, has slid from 92.2 to 14.7, having briefly hit negative territory shortly after last week’s disappointing housing-starts report. Waning upside momentum in economic data may indicate decelerating growth.
  • Profit headwinds: Supply-chain imbalances, rising input costs and higher wages could pressure company earnings in some industries. This could exacerbate less favorable year-over-year comparisons, as we move more than a full year beyond the onset of the pandemic in 2020.

In our view, these factors, along with the potential for higher taxes and central bank bond-purchase tapering, increase odds of an equity market correction and ongoing volatility. However, bouts of volatility can create opportunities for investors to shift portfolios toward quality stocks, especially those with high and defensible returns on equity and free-cash-flow yields, as well as those with favorable prospects for growth at a reasonable price. We believe investors should also consider avoiding large overweights to major passive market-capitalization-weighted indexes. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 24, 2021, “A Subterranean Correction Is Not Enough.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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