Equity investors spent most of April adjusting to the reality that economic growth is proving stronger—and inflation stickier—than previously expected. This means that the Federal Reserve may keep interest rates higher for longer: Morgan Stanley Chief U.S. Economist Ellen Zentner has raised her estimates for U.S. gross domestic product (GDP) growth in 2024 and 2025, while reducing her forecasts for Fed rate cuts.
Considering that the prospect of interest rate cuts had helped buoy stocks in the first quarter, equities have actually held up reasonably well against this backdrop. The S&P 500 Index closed up 2.7% last week, only 2.9% off its late-March all-time high, thanks to decent first-quarter 2024 company earnings results thus far as well as investors’ hope that above-trend economic growth could offset any negative effects from higher rates. While that view may prove correct, Morgan Stanley’s Global Investment Committee now sees more risk in the intermediate term.
Uncertainty Rises
Previously, the markets had priced in virtually zero chance of a recession and nearly 80% probability of a “soft landing,” in which the economy slows and inflation cools, over the next year or so. Investors’ expectation of this ideal scenario helped power the stock market’s bull run from October 2023 through March 2024.
However, with inflation still running hotter than expected, a soft landing now looks more like a 50%-probability event and a “no landing” about 20%.
Meanwhile, however, odds of the more concerning recessionary “hard landing,” in which the economy slows sharply, have jumped to about 25%-30%. There was also a hint of potential “stagflation,” a scenario in which growth stalls while inflation persists, coming from last week’s first-quarter GDP report that showed lower-than-expected growth alongside stubborn inflation.
“Haves” and “Have Nots”
Why the shift in our outlook? We believe the economy has grown more vulnerable to a boom-bust scenario as disparity grows between the largest companies and wealthiest households and other, more vulnerable sectors.
First, consider what we call the “haves.” Today, the outlook for mega-capitalization companies and large-cap multinationals, especially those tied to global manufacturing markets, appears to have brightened:
- Global economic-surprise indices, which measure the extent to which economic data are beating or missing consensus forecasts, have turned up.
- Commodities are rallying and global manufacturing purchasing-manager indices (PMIs) have rebounded, suggesting a pick-up in global growth.
- The Conference Board’s measures of CEO confidence are rebounding while capital-spending and hiring intentions are above average.
Most critically, this fortunate group seems to have been virtually immune to Fed rate hikes—whether because they possess ample extra cash, have been able to borrow at low spreads above a “risk-free” Treasury rate, or simply have a solid track record of covering the interest costs on their outstanding debt.
Now, think about the “have nots,” namely:
- Small businesses: Unlike their large-cap peers, small and mid-sized companies have seen their confidence, capital-spending intentions and hiring enthusiasm reverse sharply downward. Delays in interest-rate cuts directly affect their access to credit and capital.
- Commercial real estate, regional banks and venture-backed firms: Tighter financial conditions extend the pain for such companies in need of recapitalization. For small and regional banks, the sustained high cost of deposits and inability to lend profitably can swamp results.
- Less-wealthy consumers: U.S. consumer credit scores have fallen for the first time in a decade. Credit-card balances are at a record $1.1 trillion, while the default rate, at 6.4%, is about a full percentage point above the 15-year average.
Where these two worlds overlap and currently remain somewhat in balance is the U.S. labor market, which continues to defy expectations, with unemployment at 3.8% and private-sector hiring robust. That said, without much of a buffer, the odds that even a small uptick in unemployment could cause a boom-bust scenario or stagflation are no longer virtually zero.
How to Position Portfolios
In light of all this, investors should prepare for markets to show a fair amount of churn within a relatively narrow range. Consider bringing over- or under-weight portfolio allocations back to longer-term targets and erring on the side of diversification.
With mega-cap and large-cap stocks likely continuing to outperform small caps, think about adding exposure to international assets, staying neutral to under-weight in longer-duration bonds and corporate credit, and using real assets and hedge funds to help mute emerging risks.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 29, 2024, “Fat Tails.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
