Morgan Stanley
Wealth Management

Investor Confidence May Face a Reality Check

Jan 17, 2024

Bullish investors expect an ideal scenario of stellar corporate results, easy financial conditions and lower interest rates in 2024. Here’s why they may be disappointed.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Investors should look carefully at the market’s highly optimistic assumptions for U.S. stocks in 2024.
  • Company management may struggle to deliver on ambitious earnings targets amid obstacles to sales and profit growth.
  • Tighter financial conditions could bring down stock valuations, while interest rates could stay higher than expected.
  • In light of these risks, consider actively picking stocks and bonds, favoring REITs, gold, non-China emerging markets, Japan and hedge funds.

The U.S. stock market’s lackluster performance to date in 2024 has felt anti-climactic, coming off the dramatic surge at the end of 2023. Still, investors seem confident the U.S. economy will achieve a “soft landing” and the Federal Reserve will successfully tame inflation. As such, the equity market remains complacent, with investors’ lofty expectations leaving little room for error.

 

However, Morgan Stanley’s Global Investment Committee continues to see risks. As investors assess this year’s potential market outcomes and position their portfolios accordingly, they should ask three key questions.

  1. 1
    Will companies deliver on ambitious earnings targets?

    Analysts currently expect a roughly 10% increase in S&P 500 Index company profits in 2024. However, we believe this outlook is overly ambitious. Profit margins appear to have already rebounded toward a pre-COVID peak, which suggests additional profitability gains are unlikely, in the absence of a major positive catalyst, such as technology-driven productivity gains and falling labor costs.

     

    The economy may yet offer more such “gifts” for companies. However, we believe investors should be paying more attention to management skill as company executives deal with challenges such as softening growth in sales volumes, waning pricing power and a need to refinance debt at significantly higher rates. 

  2. 2
    Will financial conditions continue to support lofty asset valuations?

    Despite rapid Fed rate hikes, financial conditions have remained loose, helping spur the market’s recent gains. The reasons for such ample financial liquidity include massive federal deficit spending; regional-bank rescue programs; and powerful global currency dynamics that drew money borrowed from low-yielding currencies, such as the Japanese yen, into higher-yielding U.S. dollar-based assets.

     

    We believe such tailwinds are likely to reverse in 2024, however. The U.S. government’s emergency bank term-loan program expires in March, likely draining substantial liquidity from the financial system. Meanwhile, a potentially narrower differential between the U.S. dollar and the yen could direct the flow of investment capital back to Japan and out of the U.S. financial system. 

  3. 3
    Will interest rates decline to pre-COVID levels?

    Many U.S. equity investors assume the recent surge in the “real,” or inflation-adjusted, 10-year Treasury yield, to about 2%, is temporary. They seem to hope this key rate will ultimately settle around 0.5%, which would support elevated stock valuations. (Generally, government bond yields and stock valuations have an inverse relationship: Lower yields tend to make the future cash flows expected from stocks appear more attractive in widely used pricing models.)

i
Treasury yields are the benchmark from which interest rates are derived for most other forms of debt, from credit-card and mortgage rates, to yields on corporate and municipal bonds.

We believe, however, that the current yield level is the new normal, reflecting higher long-term U.S. economic growth and outsized federal deficits. If rates were to stay near the current level, they’d also be in line with the long-term average prior to the 2008 financial crisis, which touched off a decline in rates to ultra-low levels. If and when markets begin to factor in this higher-rates scenario, stock valuations will likely come under pressure.

Investing in 2024

We believe the time may have passed for investors to make the “easy money” from U.S. stocks recouping their losses in the 2022-2023 bear market. Now, establishing a foundation for a new bull market will require some heavier lifting than what the market currently seems to be anticipating. In the meantime, we expect mid-single-digit returns in U.S. stocks and bonds, with markets likely trading without extreme sustained moves in either direction.

 

In this environment, we encourage investors to build highly diversified portfolios. Consider actively selecting stocks and bonds, with a focus on areas such as real estate investment trusts (REITs), gold, non-China emerging markets, Japan and hedge funds.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from January 16, 2024, “2024 Outlook: The Forest for the Trees.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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