Morgan Stanley
  • Wealth Management
  • Jun 26, 2018

Midyear Outlook: A Market Shift Could Be Coming

It may seem like we are on an endless cycle of risks emerging, then receding. But in the fourth quarter of this year, that dynamic may change.

At a conference recently, I was part of a group casually discussing the best movies of all time. “Groundhog Day,” was mentioned a few times, which struck me as an odd choice, no offense to Bill Murray, who plays a grumpy TV weatherman stuck reliving the same day over and over.

The story line did, however, get me thinking about how it may seem like financial markets are similarly stuck on replay. Ever since Brexit two years ago, we’ve had episodes of uncertainty lead to corrections, which then turned out to be buying opportunities.

I don’t think investors should take comfort in the idea that it will be Groundhog Day forever. Underlying financial conditions have gotten more challenging this year, with interest rates rising and monetary policy tightening. Going forward, negative events may have a more lasting impact. While I don’t recommend moving now to defensive positioning, I added an overweight to utilities in June. I could see getting more defensive in the next three-to-six months.

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Acting Rational

My view is that markets now are quite rational (not beholden to a superstition involving a large furry rodent). Our call for the year is that we’ll have a volatile environment with limited upside. Our current 12-month S&P 500 target remains 2750.

Why have markets stayed flat despite the increase in risks, which include trade skirmishes, rising inflation and monetary policy tightening? It's because growth has been so strong. Earnings revisions have rarely been stronger, along with business and consumer confidence, suggesting that optimism about the future still reigns.

But while earnings have been strong, they have been offset by lower stock valuations. The price-earnings ratio of the S&P 500 was 18 at the start of the year and now is closer to 16.5.

As we near year-end, the rate of earnings growth and positive economic indicators is likely to peak. Operating margins are also likely to peak in the fourth quarter in the U.S. since tax cuts provided just a one-time boost to earnings. The market’s anticipation of a deceleration in growth is one reason valuations have fallen. Looking at the U.S., Japan, Europe and emerging markets, it’s hard to argue any region is mispriced.

Volatility to Persist

We are not looking for an economic recession in the next 12 months but we could experience the fear of one if financial conditions deteriorate further and investors begin to worry about a deceleration in earnings growth turning into an outright decline next year. I believe the S&P 500 has strong support at 16 times forward earnings per share in the absence of 10-year Treasury yields, now at 2.9%, climbing above 3.25%.

It is likely too early to worry about a major shift in market sentiment today, especially in light of the markdown in valuations that has already occurred. We think that the risk of that scenario increases as we move beyond the third quarter, when growth in earnings and margins will be rolling over more broadly.

This article was derived from the June edition of “On the Markets.” Ask your Financial Advisor if you would like to see the full report.