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3 Reasons to Remain Cautious on U.S. Stocks

Jul 12, 2023

Bond volatility, surging interest rates and a resilient U.S. dollar suggest investors should beware of the bust that could follow the boom.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Bullish stock investors seem to be shrugging off concerning contradictions in markets.
  • Bond volatility is twice its long-term average, portending turbulence for stocks as well.
  • History also suggests that recent resilience in both Treasury rates and the U.S. dollar could start to weigh on equity valuations.
  • Investors should consider Japanese and emerging-markets stocks, as well as commodities, as hedges for a peaking U.S. dollar.

The stock market rally that marked the first half of 2023 continues into the second half, as many investors cling to the optimism that has helped the market advance by 15% for the year to date. They believe the Federal Reserve will successfully tame inflation and swiftly turn to cutting interest rates, while U.S. economic growth and company earnings stay solid.

 

Such bullishness flies in the face of deteriorating economic data. Manufacturing indices from the Institute for Supply Management, which look at manufacturing-sector activity and have historically been a strong indicator about the overall direction of the economy, have been sliding for 18 months and have been in contraction territory for the last eight of those. The Conference Board’s index of leading economic indicators has been declining since December 2021, while industrial production and retail sales, adjusted for inflation, are approaching zero growth year over year. And the New York Federal Reserve’s model of recession probability is now flashing 71%.

 

In fairness, there are reasons to believe the economy may be headed for a “soft landing” without entering a recession, including tailwinds from fiscal stimulus programs and central-bank support for financial conditions. However, we also see concerning disconnects in the markets that equity investors appear to be shrugging off:

  1. 1
    Significant volatility in the bond market:

    Bond volatility, measured by the MOVE Index, has risen over the past few years and remains high; for most of the Fed’s recent rate-hiking cycle, it has been running at twice its long-term average. Meanwhile, stock market volatility, as measured by the VIX Index, has continued to decline toward lows for the current cycle. These two indices historically mirror each other closely, but this divergence has been wide and prolonged, suggesting stock investors might need to brace for higher volatility ahead. 

  2. 2
    A resurgence in real, or inflation-adjusted, interest rates:

    The 10-year Treasury bond’s real yield—an important benchmark for stock valuation—has climbed over the past few months to 1.79%, back above the level it reached in October 2022, when the S&P 500 hit its bear-market low. With all else being equal, higher rates tend to reduce stock prices as investors discount future cash flows more heavily.

  3. 3
    A resilient U.S. dollar:

    The U.S. dollar serves as an ultimate safe-haven asset and, historically, has moved inversely with stocks. This year, it’s notable that stocks have gained about 15% so far, even as the dollar has remained resilient versus other major currencies, trading in a relatively narrow range. Investors should wonder how much longer this unlikely trend will continue. 

There has been a good deal of enthusiasm in the stock market, but investors should ask if the narrative hangs together. If equity investors are truly expecting a “soft landing” for the economy, the rally should logically broaden out to include all cyclical sectors and value-style stocks, as well as small caps. However, the rally remains primarily driven by a handful of mega-cap growth stocks in technology and communications services, adding to the market’s inconsistencies with itself. Some of these things need to start lining up if the “new bull market” thesis is to be convincing.

 

At this time, investors should beware the bust that follows the boom. To help bolster your portfolio, consider adding duration by investing in longer-maturity bonds. In equities, diversify using active managers or equal-weighted indices. We continue to see Japanese and emerging-markets stocks, as well as commodities, as good hedges for a peaking U.S. dollar.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 10, 2023, “Dealing With Disconnects.” 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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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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