Morgan Stanley Downgrades Global Stocks as Growth Worries Offset Rate Support
The Street
Global stocks are set for a near-term pullback, Morgan Stanley analysts cautioned this weekend, as weaker economic growth slowly begins to offset the benefits of central bank support and U.S. corporate earnings signal a rough ride ahead for world equity markets.
Weakening global growth, most notably in the manufacturing sector, is likely to weigh on prospects over the next few months as investors fade bets on deeper Federal Reserve rate cuts and a traditional lull in summer market liquidity dampens sentiment, Morgan Stanley said, noting that, for the past 20 years, equity market returns are normally their weakest between mid-July and mid-October. Furthermore, the lack of clarity in U.S.-China trade talks following last week's G20 summit in Japan, a slump in business conditions and falling bond yields all point to equity market weakness in the months ahead.
"We think a repeated lesson for stocks over the last 30 years has been that when easier policy collides with weaker growth, the latter usually matters more for returns. Easing has worked best when accompanied by improving data," said Morgan Stanley strategist Andrew Sheets, who cut his rating on global stocks to underweight -- from neutral -- and to the lowest level in five years.
"As markets have rallied over the last month, global trade and PMI data have continued to worsen. Global inflation expectations, commodity prices and long-end yields suggest little optimism about a growth recovery," he added.
Bank of America Merrill Lynch data also suggests broader equity market caution, with its "Flow Show" report indicating a $15.1 billion exit from stocks last week against the addition of $6.3 billion in new cash into fixed income portfolios. In fact, so far this year, some $154 billion has flowed out of stock portfolios since early January, even as global stocks have topped all asset classes with a 17.7% year-to-date return.
"Relative to bonds, stocks do offer a historically elevated equity risk premium (ERP)," Morgan Stanley's Sheets argued, noting that cheap valuations have not prevented meaningful market downturns in the past. "But we think it's dangerous to be too sanguine about these supports."
"ERP is a valuation measure, and like all such measures is better as a multi-year guide than a near-term indicator, being easily swamped by more pressing concerns."
Corporate earnings could be one of those concerns, with more than 87 S&P 500 companies issuing negative guidance and FactSet data suggesting collective earnings will fall 2.6% over the three months ending in June, marking the first back-to-back quarterly decline in three years.
Bond markets, too, are warning investors of a potential recession -- a condition the New York Fed thinks has a one in three chance of materializing over the near-term -- via a persistently inverted yield curve.
Benchmark three-month Treasury bill yields have been trading north of 10-year note yields since late May, when the so-called curve inversion kicked in as equity markets retreated in the wake of a collapse in U.S.-China trade talks and a string of grim manufacturing data readings from the world's biggest economies.
The inversion has more or less held since then, however, even with a more optimistic outlook on U.S. China trade talks and a stronger-than-expected June employment report that showed 224,000 new jobs added to the economy last month.
Morgan Stanley's Sheets acknowledges the upside market risks, however, and notes that the current bull market has been defying expectations for nearly a decade.
"The greatest risk, in our view, is that the growth data bounce but central banks still follow through with aggressive easing," he said, adding that if investors really are convinced of the power of cheap stocks, "they have an odd way of showing it" by favoring growth, quality and defensive plays over riskier ones.