Morgan Stanley
Wealth Management

Look Out for the End of the Equity Rally

Jul 26, 2023

Despite favorable conditions for the U.S. economy and markets today, investors may still want to brace for a pullback.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • An ample supply of money in circulation has cushioned the U.S. economy and corporate profits from the impact of Fed rate hikes.
  • Also, many U.S. households and companies have locked in low interest rates, making them less sensitive to monetary tightening.
  • Still, recent data suggest the economy remains vulnerable and that investors may want to brace for another pullback in markets. 
  • Consider rebalancing investments toward value-style and “growth at a reasonable price” stocks as well as fixed income. 

The S&P 500 Index has advanced by 27% over the past nine months, with gains accelerating considerably in the past six weeks. This may seem extraordinary, and some investors’ enthusiasm around equities has led them to call the beginning of a bull market. But these recent gains aren’t all that different from prior bear-market rallies: In fact, in all seven bear markets since 1960, stocks have come close to reaching their prior highs before falling to their ultimate lows for the cycle, which is why we think investors may want to remain cautious today.

 

Sustaining the Gains – for Now

Should investors expect history to repeat itself, sending the current highs of the bear-market rally to new lows? Despite extensive tightening to monetary policy over the last year, two factors have kept the economy and markets buoyant and may do so for a while longer:

 

  • The sheer amount of money in circulation has helped to cushion the U.S. economy and corporate profits. The country’s “M2” money supply—which includes money in checking accounts, certificates of deposit and money market funds—sits at $20.8 trillion as of May. That’s down only slightly from a record high in July 2022, after pandemic-related government stimulus caused the supply to rise sharply in 2020 and continue to grow well into 2022, leaving still ample liquidity today.

 

  • Many U.S. individuals and companies have locked in low interest rates, which shores up their balance sheets. For many years prior to the recent Federal Reserve rate hikes, households and companies alike were able to borrow at historically low rates—think 2.65% for the average 30-year fixed-rate mortgage as of January 2021. This has made them less sensitive to the rapid rise in rates over the past year. 

 

Investors Should Still Be Cautious 

Together, these two factors have helped to keep the U.S. economy and corporate profits unusually resilient. But while stock market momentum is tempting, Morgan Stanley’s Global Investment Committee believes the current rally is driven by investors’ optimistic confidence in re-accelerating economic growth, the taming of inflation and falling interest rates in 2024. This bullish outlook ignores recent data signaling a more difficult road ahead: Industrial production is softening; The Conference Board’s composite index of leading economic indicators is deteriorating; existing home sales are weak; and bankruptcies are rising, as are the provisions that banks set aside for loans going sour.

 

In light of these concerning crosscurrents, we continue to emphasize caution. Investors should consider trimming the gains they’ve attained through passive exposure to U.S. stocks indices and rebalancing toward value-style and “growth at a reasonable price” stocks. Also look to fixed income, where increasingly solid real, or inflation-adjusted, yields are available.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 24, 2023, “Leads, Lags and Levels.” 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.

Disclosures

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.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice.  Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.

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