Since interest rates peaked in late May, both stocks and bonds have rallied strongly over the first half of June. Yields on 10-year Treasuries (which move in the opposite direction as prices) have fallen below 4.25%, while the S&P 500 Index is yet again near all-time highs.
These moves follow a deluge of data suggesting that the labor market and inflation are cooling, which supports the Morgan Stanley Global Investment Committee’s expectation that the economy will achieve a “soft landing” in which inflation fades and growth slows without a recession.
However, while recent data may reflect some improved clarity in the state of the economy, and while the markets’ response to it may seem logical, a closer look suggests that stock and bond markets are rising for different reasons. Investors should be mindful of these divergent perspectives, as the outcome could present opportunities and risks for investor portfolios.
- Fixed-income markets seem confident in a soft landing, with expectations of slower growth and cooling inflation helping drive the recent drop in 10-year Treasury yields. Bond investors also seem optimistic about interest-rate cuts, with the futures market now pricing 2.6 rate cuts by January 2025, despite the U.S. central bank’s latest projections of just one. While that disconnect may be a source of near-term volatility, we believe bond markets are more closely aligned to Morgan Stanley’s expectation of a soft landing and pricing it fairly.
- Equity investors, meanwhile, seem less convinced of the narrative around a soft landing, as the stock market’s move higher has been concentrated around generative AI. Consider that the S&P 500 Index achieved its most recent all-time high with only 30 stocks reaching new highs. This lack of “market breadth” not only shows the excitement around advances in AI, but also seems to betray a lack of confidence in a soft landing: If stock investors, like bond investors, truly believed that inflation is cooling and that the Fed will cut rates more than once before 2025, then cyclical, small-cap and bank stocks would likely be working for investors, but they’re not. This indicates an underlying defensiveness in the equity market, with the prospect of lower rates only helping the market’s richly valued high-flyers.
A Shift Ahead for Stocks?
The current combination of high stock-index concentration, increasingly rich valuations and lofty investor expectations warrants caution.
So far in the second quarter, the high-flying “Magnificent 7” mega-cap tech stocks are collectively up more than 15%, while the other 493 stocks are down 2%. Granted, more than 60% of the S&P 500’s earnings growth over the last 12 months has come from the Magnificent 7. Still, earnings growth for the other 493 stocks in the index has not been negative.
However, analysts’ earnings estimates suggest these trends may reverse in the second half of the year, with earnings growth accelerating for the other 493 stocks and decelerating for the Magnificent 7.
If a soft landing materializes, as we believe it will, stock-market gains should become more broad-based, with quality cyclicals and defensives likely driving markets higher.
The potential shift in market dynamics may present opportunities to invest in equal-weighted equity-index strategies, which seek to allocate equal amounts of capital to each constituent in the index, or to actively pick stocks with a focus on quality cash flows and management’s ability to deliver on earnings expectations.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 17, 2024, “Déjà Vu All Over Again.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
