Morgan Stanley
  • Wealth Management
  • Jul 13, 2020

Weighing Risks to U.S. Markets

As the S&P 500 hovers near an all-time high, investors may be missing the signs of some mounting economic risks.

This is a challenging time for our country and, by extension, U.S. markets. The S&P 500, the main barometer of U.S. stocks, has been treading water in recent weeks at a level just 5% below its all-time high. Certain economic risks are clearly growing, yet the ones that concern me the most aren’t the same ones many investors seem to be worrying about.

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Let’s start with the risks that many investors may be overestimating:  

  • COVID-19 Resurgence: The increase in U.S. cases is troubling and likely will disrupt the economic recovery in some sectors. Still, we remain convinced of a V-shaped rebound in the broader global economy. As long as the growth in COVID-19 infections doesn’t result in hospital-system breakdowns, we forecast economic gains continuing and Americans powering through.
  • Trade Tensions: We believe that investors have less to fear than headlines suggest. While tensions with China are likely to dominate the election rhetoric of both parties, the fragility of the global recovery during this pandemic suggests that world leaders will maintain a much more pragmatic stance that keeps trade policy unchanged.
  • U.S. Post-Election Policy Shifts: Politics may loom large, but  material policy shifts seem unlikely in the near term. While many polls now suggest that a Democratic sweep in November is plausible, we don’t see immediate tax hikes and costly expansions of the healthcare system as a likely outcome.

Here are three key risks that investors should focus on more:

  • Disappointing Earnings: The risk that many companies may miss earnings expectations has grown, especially as more of them pull their guidance due to economic uncertainty. Meantime, investors are crowding into a handful of popular tech names with sky-high valuations. How can these companies generate positive guidance and upside surprises when expectations are already so high? Investors have shunned defensive sectors, such as utilities and real estate investment trusts that they normally turn to in times of elevated uncertainty—placing their faith only in large-cap tech outperformance.
  • Rising Inflation: Inflation expectations have already begun to rise. One inflation measure, the 10-year “breakeven” rate, has risen from 0.5%, in late March, to about 1.4%. While that is well below the Fed’s target rate of 2%, the combination of money-supply growth and a weaker dollar, among other factors, point to rising inflation expectations that could raise long-term interest rates and lower equity valuations.
  • Legislative Inaction on More Stimulus: Congress will be going into August recess soon. Failure to extend unemployment benefits would likely expose the growing level of permanent job losses that are appearing below the surface of the economy. States and municipalities, suffering under the weight of lower tax revenues and increased costs due to the health crisis, need financial backstops. Without income replacement and other offsets, the pain of this recession could bite deeper for many Americans. That could lead investors to reduce risk in their portfolios by selling stocks.  

My advice to investors: Put emphasis on diversification, adding gold, corporate credit and international stocks to portfolios that are overweight the S&P 500 index. Meantime, look for July fiscal stimulus renewal and tech-sector earnings guidance, which could alleviate some of the concerns I’m most focused on.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 13, 2020, “Gauging Risks.” Ask your Financial Advisor for a copy or find an advisor.  Listen to the audiocast based on this report.