The Warning Signs Investors Should Not Ignore

U.S. stock and bond investors haven’t seen eye-to-eye lately.

Equity investors seem to have largely shrugged off concerns about the path of monetary policy and the U.S. economy. In the past week alone, the Cboe Volatility Index (VIX), which measures expected volatility in U.S. equities and functions as the stock market’s “fear gauge,” fell to its lowest levels in 17 months. The S&P 500 Index has gained about 5% over the past month and is just shy of its January 2023 high.

Meanwhile, Treasury bonds have continued to reflect recession risks. Bond-market volatility has soared and remains in a range like that at the onsets of the COVID pandemic in March 2020 and the Great Recession in 2008. And recent Treasury yield movements imply a 78% probability of recession in the next 12 months.

Should investors buy into the equity market’s optimism or heed the cautionary signals in fixed income?

Morgan Stanley’s Global Investment Committee believes now is a time for investors to take caution, given that business conditions are worsening and today’s historically easy financial conditions are apt to fade.

Business Confidence Wanes

With forecasts suggesting 12% profit growth in 2024, investors seem to hope that earnings growth will prove to have bottomed out in the first quarter of this year and then resume its upward trajectory. However, the rapid deterioration in metrics around small and medium-sized businesses offers a more sobering outlook.

In fact, recent surveys by the National Federation of Independent Business (historically strong leading indicators of S&P 500 earnings) show a marked decline in business sentiment, reaching a 40-year low in the share of respondents saying that “now is a good time to expand.”  Demand and pricing power indicators also fell alongside weakness in wage expectations and hiring intentions, which usually portends a rise in unemployment claims. 

Financial Conditions Could Tighten

Although there is greater financial liquidity today than in the average of the last 40 years—and just as much as in June 2022, when the Fed had only begun raising interest rates—these accommodative conditions could recede. Here’s why: 

• Recent banking turmoil suggests that severe credit contractions are coming, with regional banks’ year-over-year deposit and credit growth having already turned negative.
• The federal debt-ceiling debate is starting to take shape in earnest, and rhetoric from a deeply divided Congress may have a destabilizing effect on financial markets. However, we fully expect Congress to lift the borrowing limit.
• A wave of Treasury issuance may ensue once Congress ultimately agrees to raise the debt ceiling. This could drain the financial system of $650­ billion to $750 billion in the second half of this year.

Investors Should Remain Patient 

Disconnects between stock and bond narratives don’t last forever. Eventually, data and market events tend to validate one scenario or the other, and we may see this reckoning take place in the next three to six months.

For now, investors may want to wait out uncertainties around policy, recession risks and corporate earnings. We prefer the risk/reward profile of high-quality fixed-income investments and believe investors should focus on income opportunities in both stocks and bonds, avoiding market-cap-weighted indices where risks are concentrated and negatively skewed by extreme valuations.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 24, 2023, “Trough Earnings or Peak Liquidity?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.