Is the U.S. Market Due for a Breather?

Major U.S. stock indices charged higher in August, regularly setting new highs, but more out of “climbing the wall of worry”—as in, the market’s tendency to move up even against a host of negative factors—than based on any economic or profit fundamentals. 

This means that stock-price resilience likely reflects an overpriced market. Indeed, many investors seemed to have ignored numerous risk factors, including the resurgence of COVID-19 hospitalizations in the U.S., falling consumer confidence, higher interest rates and significant shifts in geopolitics in China and the Middle East.

Why has the market been so complacent? We believe that today’s market dynamics are increasingly responsive to nuanced communications from the Federal Reserve, which seems to have successfully convinced investors that central bankers can thread the policy needle without mistakes. At its recent annual Jackson Hole Economic Symposium, for instance, the Fed reiterated its view that inflation will likely prove transitory, meaning it’s in no rush to raise interest rates.

While both stock and bond investors cheered, questions remain about asset bubbles and financial stability. In particular, even amid steady optimism about the overall U.S. economy, we are increasingly concerned that markets are vulnerable, specifically to two factors that could serve as catalysts for a pullback.

First, there’s the issue of interest rates. We see real rates rising, not only as the Fed is expected to start reducing its bond purchases but also as global economies recover, which could encourage foreign investors who have flocked to Treasuries as a “safe haven” to move their money elsewhere.

Higher rates also could pressure stocks’ price-to-earnings multiples, which currently sit well above historic norms. Investors in small-capitalization stocks, cyclicals and dividend-payers generally seem to have factored in the risk of higher rates, as those stocks have retreated from their year-to-date highs. But not for mega-capitalization technology leaders, which dominate the S&P 500 Index.

Second, corporate earnings may not be as robust going forward. Year-to-date earnings have been spectacular—full-year 2021 earnings estimates are up by more than 20% from their levels at the start of the year. However, we are concerned about the sustainability of operating margins, given the headwinds to corporate profitability: higher taxes, more aggressive regulation, higher input costs, higher cost of labor and a weaker U.S. dollar.

Investors may be confident in companies’ abilities to offset these factors, for example, by raising prices. But that view doesn’t quite jibe with the notion that rising inflation is merely transitory.   

These two factors—the anticipation of higher rates and lower earnings— may fuel a near-term market correction, which ultimately could help investors digest this recent historic rally and reconcile themselves to the reality of less liquidity and higher rates and inflation. Such a breather could help restore risk premiums and preserve potential returns for the selective stock picker.

Investors can prepare their portfolios by rebalancing from index accounts toward high-quality cyclical stocks, as well as dividend-paying names in consumer staples, consumer services and health care.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Sep. 7, 2021, “Catalysts for Correction.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.