Equity investors appear optimistic, but U.S. government bonds, gold and oil tell a less encouraging story.
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Stocks have continued their rebound into 2023, delivering one of the best openings to a calendar year since January 2000.
The buoyant mood intensified last week following the Federal Reserve’s widely expected quarter-point interest rate hike. Even as the Fed confirmed its commitment to fighting inflation, with no rate cuts likely in 2023, investors took the S&P 500 Index to its highest levels since last August and the volatility gauge to its 52-week low. Many equity investors, it seems, continue to see a new bull market underway, based on an optimistic scenario in which the Fed successfully tames inflation with only modest slowing in economic growth, corporate earnings and employment.
Morgan Stanley’s Global Investment Committee, however, believes recent equity gains are merely another bear market bounce—not the beginning of a sustainable bull market. As noted last week, the current rally seems to be based not on improving economic fundamentals but on easing financial conditions, which we believe are likely to reverse later this year.
What’s more, even as stocks trade higher, recent market action for other asset classes paints a starkly different picture. There are three that merit particular attention:
- U.S. government bonds: Treasury yield curves remain deeply inverted, a time-tested signal that an economic downturn is on the horizon. With yields on shorter-dated debt higher than on longer-dated debt—indicating that investors collectively see more risk in the near future than down the road—the important 2-year/10-year Treasury yield curve is inverted by more than 70 basis points, the most in decades.
- Gold: Since the October low for the S&P 500, gold continues to outperform both the S&P 500 and the Nasdaq. This is curious given that many investors view gold as a safe haven when turbulence looms. While the price of gold likely got a boost from rising risks around the U.S. debt ceiling, it likely would not be maintaining this level if economic growth were in fact stabilizing or rebounding, as stocks seem to indicate.
- Oil: If equity investors are expecting a “soft landing” and potential rebound in economic growth later in 2023, oil prices do not reflect that. Crude oil futures, for example, are down 8.6% year-to-date and 18.7% from a year earlier. Consensus expectations for oil suggest that falling demand in the U.S. could offset any demand gains from a recovery in China.
We remain cautious about the direction of the equities market this year, as these other assets do not confirm the optimistic outlook implied by stocks’ performance. Equity investors are sending prices and valuation multiples higher, with little consideration for broader implications. The likely impacts of tightening monetary policy, corporate earnings vulnerability and uncertainty around the path of inflation are additional reasons for prudence.
For the “soft landing” outlook held by equity investors to be validated, we would need to see steeper yield curves, weaker gold prices and stronger performance in energy. Meanwhile, investors should focus on income generation as this period of heightened uncertainty plays out. Continue to focus on short- to intermediate-term Treasuries, municipal bonds, investment-grade corporate bonds and dividend-growth stocks.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from February 6, 2023, “Market Disconnect.” Ask your Morgan Stanley Financial Advisor for a copy.
