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.

Mike Wilson Chief Investment Officer

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.

Risk Considerations

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

 

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

 

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

 

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence.

 

Investing in foreign and emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. These risks are magnified in frontier markets.

 

Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy.

 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Besides the general risk of holding securities that may decline in value, closed-end funds may have additional risks related to declining market prices relative to net asset values (NAVs), active manager underperformance, and potential leverage. Some funds also invest in foreign securities, which may involve currency risk.

Companies paying dividends can reduce or cut payouts at any time.

 

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

 

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Credit ratings are subject to change.

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