The recent correction may have been inevitable given rising risks for fiscal stimulus, a potential COVID-19 second wave and the upcoming election. But a resolution to these hurdles may also be possible longer-term.
Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, September 28th, at 10:00 a.m. in New York. So let's get after it.
Over the past month, several key risks to markets have surfaced, producing the first meaningful correction in this new bull market. More specifically, the S&P 500 dropped over 10% from its recent highs, led by a 14% decline in the tech heavy Nasdaq 100. Truth be told, I thought this correction would actually arrive in August. But instead, equity markets went higher in August as real 10 and 30 year yields made all-time lows, and retail investor speculation in call options surged. Timing is everything, as they say, and the correction this month is happening for the same reasons I suspected back in August.
First, with Congress embroiled in election year politics and a disagreement over when to fill the Supreme Court vacancy, the odds of the CARES2 legislation getting passed before November 3rd have dropped considerably. Morgan Stanley public policy strategist Michael Zezas thinks it's just a 33% chance at this point. Second is COVID-19 and the looming arrival of a second wave. Until we know exactly what it looks like, further lockdowns remain a real possibility. Third, real long term interest rates appear to have bottomed as the Fed formally tells us asset purchases won't increase from here. And finally, we have the election itself.
The good news is that investors have started to discount these very visible concerns via lower prices and higher financial market volatility. Options markets are pricing in higher risks than normal around the U.S. election, but nothing like we actually experienced in 2016. That doesn't seem right, given the uncertainty around the election outcome and the process itself. As a result, I expect volatility to remain high for the next 4-6 weeks, creating what is likely to be a difficult trading environment with a wide band for the major averages.
Looking beyond the near term, I think three of the aforementioned risks are likely to be resolved positively by the end of the year, or shortly thereafter. More specifically, additional fiscal stimulus is likely as both parties want to spend more but may not be able to come to terms before the election process is completed. Meanwhile, progress on a vaccine should become clear, and we will eventually have a conclusion to the election. The one risk I think will remain with us is that long-term interest rates are likely to rise further from here, particularly if those other risks fade and the recovery continues.
The bottom line is that the recent correction was inevitable, in my view, as all bull markets consolidate along the way, especially when the initial rally is so powerful. Timing such corrections is difficult and this time was no different. If you share our view that these near-term hurdles will be cleared by year-end, then the recovery can continue in 2021. This implies that stocks most levered to an ongoing recovery should be one's area of focus. They include consumer cyclicals and services, materials, industrials, and financials, to name a few. Finally, we like high quality growth stocks once they have fully adjusted to the rise in long-term interest rates we expect.
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