How much 'runway' is there for risk assets? Morgan Stanley Research Strategists say the days of easy gains may be over, but here’s why it won’t be another 2008 scenario.
Investors have had more than their share of nail-biting moments over the last nine years, from the flash crash and taper tantrum, to the eurozone crisis and commodities collapse.
To be sure, cyclical peaks do make for choppy returns—and this transition will likely feel jarring after nine years of relatively smooth sailing.
Yet, investors of the future will likely look back at this period as easy, with accommodative central bank policy, low volatility, strong equity returns and declining interest rates all working in investors’ favor.
“All of this now appears to be changing, and all at once,” says Andrew Sheets, Morgan Stanley’s Chief Cross-Asset Strategist, noting that many positive forces are now shifting, sending cyclical and structural tailwinds swirling. “This is what we call the 'tricky handoff', and it suggests not just a harder environment, but a fundamental shift in how we approach the market.”
In their recent Global Strategy Mid-year Outlook, “The End of Easy,” Sheets and his Morgan Stanley Research colleagues revisit the concerns they laid out heading into this year. Their current outlook: Stocks and corporate bonds in most major markets are at or near their cyclical peaks.
“The first quarter of 2018 was not an aberration, but rather a sign of a changing regime,” Sheets says. The equity bull market, having already been extended by tax changes and other factors, now has limited runway and is already exhibiting signs of a typical topping pattern marked by peaks in credit, yield and equities, in that order.
To be sure, cyclical peaks do make for choppy returns—and this transition will likely feel jarring after nine years of relatively smooth sailing. This market top, however, won’t necessarily be marked by the double-digit declines seen after 2000 and 2007, says Sheets. “Those were the largest equity and credit bubbles in modern history—respectively—and today's excesses aren't nearly as extreme.”
Meanwhile, the global economy is poised to continue growing at a healthy pace. Morgan Stanley economists recently bumped up their forecast for global real gross domestic product (GDP), which is on pace to increase to 3.9% in 2018 and 3.8% in 2019.
So in light of above-trend global growth, what could a topping process look like? For markets, of course, timing is everything. While Morgan Stanley’s cross-asset team is looking at reducing risk now, U.S. strategists believe stocks could mount one last rally into the third quarter as earnings estimates continue to rise amid a still-strong economic backdrop.
Historically, equities have tended to top roughly 9-12 months after a credit spread trough. Assuming the credit trough was late January/early February 2018, “normal” timing would put an equity peak in November/December of this year. 10-year U.S. Treasury yields, in turn, tend to peak around three months ahead of stocks, which would place that peak in August/September 2018.
What could change this outlook for better or worse? “One clear risk would be that a rise in inflation, decline in manufacturing and poor summer seasonality could lead to large outright declines,” says Sheets. A more bullish view notes that valuations for global equities remain far below levels seen at prior cycle peaks. In addition, the C-Suite still has high levels of confidence. Financing is still plentiful and cheap and M&A volumes, adjusted for market cap, remain well below prior cycle peaks.
This global expansion is, in most cases, already reflected in asset prices—but regional variations are profound. Michael Wilson, Morgan Stanley’s Chief U.S. Equity Strategist and Chief Investment Officer says amid a host of factors that are potentially inflecting in 2018, investors should note one more: The performance of U.S. assets versus the rest of the world, across equities, rates and credit. Wilson notes that in all three asset classes, simultaneously, the U.S. versus rest of the world differentials are near all-time wides.
RoW Equities Offer Higher ERP and Are Starting to Outperform U.S. Equities
(Upper: Cumulative Performance Since 2010)
(Lower: Equity Risk Premium %)
While the growth in U.S. earnings has been hearty, relative margins, valuations and equity risk premiums are reason for investors to be wary. U.S. credit yields relative to those of the eurozone and UK are the widest ever recorded; leverage for U.S. corporate credit is near all-time highs, while European high yield credit is near all-time lows.
“Against the shift in the market backdrop, we think that strategic implications are clear: USD investors should consider shifting their equity and credit exposure overseas, especially toward Europe,” Sheets says, explaining that this view is supported by fundamentals and valuations, as well as carry. “Thanks to the wide yield differentials, USD investors are paid handsomely for buying assets in markets like Europe and Japan, and hedging the currency exposure.”
USD Investors, Strategically, Should Invest Abroad and Hedge the FX
FX-Hedged Yield (%)
Other key investment themes to navigate during this “tricky handoff” include:
- Reducing global equities: Morgan Stanley’s cross-asset team has shifted its global equity weighting from overweight to equal weight; Europe remains their top region, followed by the U.S., emerging markets and Japan, in that order. In addition, the team is overweight energy and financials globally.
- Look at the long end of the curve: Strategists remain neutral on government bonds overall but have a strong relative preference for U.S. Treasuries. They forecast U.S. 10-year and 30-year yields to end the year lower with a flatter curve.
- Tread carefully with credit: They remain underweight (-5%), with the most negative views on corporate credit, and a more neutral outlook for securitized debt. That said, recent spread widening and better underlying fundamentals have prompted them to increase their weight to EM hard currency debt.
- Assume a weak U.S. dollar: Strategists are calling for significant strength in Japanese yen, and U.S. dollar weakness, which should boost EM FX performance.
- Constructive on oil: The team notes that geopolitical developments, stronger demand dynamics and inventory draws should keep oil prices supported in the near term.