Morgan Stanley
  • Wealth Management
  • Feb 22, 2021

Consensus on Recovery Could Lead to Market Instability

Investor optimism about the pace of the U.S. economic recovery is generating new market highs, but could also lead to market instability.

It’s hard to argue with optimism. Both the U.S. stock and bond markets have reached new highs, as consensus builds around our long-held thesis for a V-shaped economic recovery in 2021. The dramatic recent improvement in COVID-19 infection rates and vaccine distribution has cemented pro-cyclical sentiment, initially based on the success of stimulus measures from both the Federal Reserve and Congress. 

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Other factors have also driven confidence. The strong fourth-quarter 2020 earnings season suggested that the recession’s damage to profits may already be in the rearview mirror for many companies. Recent economic data have also proven strong, with better-than-expected January retail sales and higher wholesale prices that point to global reflation.

The looming problem now? Investors seem so in-sync about where the economy and markets are heading that it could create risks for later this year. 

Markets Reach New Extremes

Valuations aren’t only high, but at extremes in nearly every asset class we follow. Pro-growth asset classes, such as cyclicals, emerging markets and small-capitalization stocks that lagged behind the broader market last cycle are now outperforming. International markets, too, have come alive. The MSCI World Index, which covers mid- and large-cap stocks in 23 developed markets, now has a price-to-earnings ratio of 28, its highest level since 2009. These cross-asset correlations could mean that portfolio diversification may not work as planned. 

Meanwhile, interest rates are rising. The 10-year Treasury yield is near 1.4%, up almost three times from its 0.5% low last August. That rise affects stock valuations, since equities are often judged in comparison to the amount that can be earned on a low-risk Treasury bond. Rates are still very low, but it is natural to ask when the upward move in the cost of capital will start to be a headwind for companies. We think we are getting close.

If consumer and wholesale prices continue to rise at the same time as the cost of capital, that could stall further earnings outperformances. Higher materials costs arriving just when companies are rehiring workers could lead to dips in profit margins. 

Potential Inflation Surprise?

Inflation expectations have risen. The Producer Price Index, which measures inflation at the wholesale level, jumped 1.3% in January, the largest month-over-month increase since December 2009. The Fed has advised investors that a pick-up in prices is likely transitory. However, could a higher-than-expected inflation rate force the Fed to reign in its accommodative policies?

We don’t expect these risks to materialize until well into the second quarter. Meanwhile, the rosy recovery outlook will likely drive markets, which often overshoot to the upside, amid high investor confidence and plentiful positive catalysts.

Our advice for investors: Be increasingly selective and focus on securities with low relative valuations that don’t tend to correlate with the broader market, thus, potentially delivering the benefits of diversification. Consider taking profits in winners and rebalancing portfolios toward defensive names, such as high-quality dividend-paying stocks.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Feb 22, 2020, “Extremes Hitting Resistance.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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