Morgan Stanley’s Global Investment Committee recommends that investor portfolios be overweight stocks and underweight bonds.

This is an edited excerpt from the Nov. 18, 2014 edition of “Positioning,” by Michael Wilson, Chief Investment Officer, Morgan Stanley Wealth Management. The full report is available upon request. Please refer to the Disclosures section of the excerpted report for important information and disclosures.

The Federal Open Market Committee’s (FOMC) October decision to end quantitative easing, withdrawing stimulus from the economy, marks the start of monetary tightening, or the second stage of recovery. This phase is typically characterized by rising stock, or equity, prices and interest rates.

On the heels of that decision by the FOMC, the Federal Reserve’s policymaking body, Morgan Stanley Wealth Management’s Global Investment Committee (GIC) recommended that investors position their portfolios to overweight equities and underweight fixed income, or bonds.

The GIC, a group of seasoned investment professionals who meet regularly to review the economic and political environment and asset allocation models for Morgan Stanley Wealth Management clients, expects the economy—as measured by gross domestic product, or GDP—to grow, but at below the rate to which we have become accustomed, based on prior second-stage recoveries; stock and bond returns will likely follow suit. This is attributable, in large part, to still lackluster consumer spending and the significant reduction of debt (bank lending and corporate and household borrowing), which fueled the economic growth of the past 30 years.

Investors should not interpret this low-growth environment as a precursor to a recession or a stock market correction. On the contrary, corporations have generated record profits and impressive earnings, not by growing organically, but by cutting costs. The GIC doesn’t expect this performance to change in the foreseeable future, so long as interest rates stay relatively low and inflation remains in check.

In the absence of a pickup in consumer spending, annualized, real GDP—adjusted for inflation—is forecast to be between 2% and 2.5%, instead of the 4% average since World War II, and annualized returns on US equities and investment-grade bonds is estimated at 4% and 1%, respectively, for the next 10 years.

Here’s why the domestic equity market is the GIC’s asset class of choice during the next 6 to 12 months:

The Equity Environment

Corporate earnings were very strong in the third quarter. For the period ended Sept. 30, 2014, the S&P 500® companies, a representative sample of 500 large companies in leading US industries, delivered nearly 10% year-over-year earnings-per-share (EPS) growth on an increase in sales of just 4%. Energy companies, which have had to contend with falling oil prices, delivered more than 7% EPS growth on a 3.5% decline in revenues.

In addition, midterm elections have historically marked a good time to own domestic equities. In the prior 27 midterm periods, the S&P 500 has rallied 12% on average during the 10 months following the election; the return jumps to 22% when the Fed is in the middle of a tightening cycle.

Declining energy prices are another possible catalyst. While some investors fear this may signal an economic global retrenchment, the GIC believes it is more due to excess supply. The oil price drop will act as a sizable tax cut for the global consumer, and this should begin to boost growth well into 2015.

Finally, US wages and income are on the upswing. Although average hourly earnings in October moved up only 0.1% month-over-month, the annualized rate has continued to grow at about 2%, in line with the trailing four-year average. In addition, hours worked have continued to increase, hitting a six-year high.

Equities: The Opportunity

  • Small- and mid-cap domestic equities should offer opportunities because they are more exposed to an accelerating US economy and less to decelerating emerging markets.
  • The GIC prefers sectors that historically outperform during the mature phase of a recovery: health care, technology, domestic industrials and consumer discretionary.

Equities: The Risks

  • A rapid increase in interest rates could have negative implications for US small- and mid-cap stocks.
  • Change in the composition of the FOMC and confusion surrounding forward guidance may lead to increased volatility in equity markets.
  • A string of disappointing economic data could raise questions about the strength of the US economic recovery.

Fixed Income: The Opportunity

For fixed income, investors are advised to be selective. With interest rates expected to rise, long duration bonds1 will offer little value, while shorter duration fixed-income securities may provide more opportunity. In particular, the GIC recommends:

  • US high yield, with an overweight to bonds rated BB/BBB.
  • Floating-rate notes, which may offer support against rising rates while providing a better return than cash.
  • Opportunities outside of traditional fixed income, for example, stocks with rising dividends, real-estate investment trusts (REIT) and master limited partnerships.
  • Staggering the maturities of your fixed-income holdings to take advantage of rising interest rates (bond ladder).

Fixed Income: The Risks

  • Economic growth slows and interest rates decline instead of rise.
  • Shorter‐duration bonds do not provide the same degree of portfolio diversification as longer‐duration bonds.

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