Why U.S. Stocks Remain Vulnerable

U.S. stocks closed the first quarter with solid gains. The S&P 500 Index rose 7% and the tech-heavy Nasdaq went up 17% in one of its best quarters since 2020. The indices are up about 15% and 20%, respectively, from their 2022 lows, inviting many investors to declare the bear market over. But we believe that such a call is premature.

Today’s stock-market resilience, even in the face of extreme bond-market volatility, demonstrates that investors continue to ignore genuine risks to the economy and corporate earnings. Investors appear to be operating rather single-mindedly, focused only on a potential decline in long-term interest rates back to pre-COVID levels, since lower rates would mean higher stock valuations.

Adding to our concern are emerging stresses in other asset classes, particularly those vulnerable to higher rates and tightening lending standards. Cracks in those markets could add new headwinds to the investing environment and the broader economy.

Assets to Watch

Two asset classes—commercial real estate and private markets across venture capital and private equity—warrant particular attention.

Commercial real estate (CRE): Investors have sharpened their focus on this sector, given regional banks’ significant share in CRE lending. Even before the banking-industry turmoil, however, CRE was facing risks from long-term trends, with remote work threatening the office sub-sector.

What’s more, the sector is now facing a huge “refinancing wall”: More than half of the $2.9 trillion in commercial mortgages will be up for refinancing in the next couple of years. Even if current rates stay where they are, new lending rates are likely to be 3.5 to 4.5 percentage points higher than they are for many of CRE’s existing mortgages.

Commercial property prices have already turned down, and Morgan Stanley analysts forecast prices could fall as much as 40%, rivaling the decline during the 2008 financial crisis. These kinds of challenges can hurt not only the real estate industry, but also entire business communities related to it. 

Private markets across venture capital (VC) and private equity (PE): The collapse of Silicon Valley Bank put a spotlight on the already-stressed VC industry. VC-backed businesses continue to burn through their cash reserves, and additional cash infusions are less likely to be forthcoming as VC firms and the businesses they back cope with higher capital costs and restricted access to funding. These challenges will likely have knock-on effects for the broader economy and markets: VC-funded companies employ more than 5 million people and generate revenues for many companies with publicly traded shares.

In private equity, opportunities do exist, given that the industry sits on roughly $2.3 trillion of available capital that it can deploy opportunistically. However, the overall market is likely to see a multi-year slowdown in new fundraising as investors rethink their capital commitments amid market and economic uncertainty. What’s more, a dimming economic outlook means the investments that PE firms have made in portfolio companies over the past couple of years face markdown risks and those companies, themselves, may need capital injections. 

Stocks Are Still Susceptible

It’s important to remember that few sectors and asset classes exist in a vacuum. Price declines and markdowns in valuations in these more-illiquid strategies ultimately impact the broader market. U.S. stocks, even high-flying tech and consumer discretionary companies, are unlikely to be immune.

Consider rebalancing your portfolio with a keen eye to the likelihood of markdowns on illiquid asset classes. If you’re thinking about alternative investments, remember that CRE, VC and recent-vintage PE investments are especially vulnerable. Private credit remains our preference among private-market strategies over the next 12 months.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 3, 2023, “Not a Port in the Storm.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.