Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 1st, at 1:30 pm in New York. So let's get after it.
Last week I discussed higher interest rates as a risk to equity valuations. While not a new topic, last week felt like a tipping point for bond investors, as they could no longer ignore the strong economic data. There's also an increasing likelihood of another fiscal stimulus bill getting passed, despite the plunge in COVID cases and hospitalizations.
With the next round of fiscal stimulus checks likely to go out by the end of the month, and the economy likely to reopen shortly thereafter, the markets are starting to contemplate what that means for the demand of real goods and services. It's not hard to see how inflation could really spike in the spring and bond markets are starting to take notice. For the record, we've been on this train for a while, recommending clients focus on investments that can benefit from these rising prices and interest rates. Fortunately, the market has been on the same page, with cyclicals, small caps and other inflationary beneficiaries like commodities, outperforming the most.
But now interest rates are finally catching up, and that is pushing down valuations faster than earnings revisions are moving up. This is very natural at this stage of an economic recovery from recession. It's also very much in line with our call for this year: higher rates, lower valuations and strong earnings. What it means for investors is that 2021 is likely to be a year of modest returns for the major indices, but with massive dispersion between winners and losers. Our research over the past few weeks has focused on specific opportunities where the upside is underappreciated, while avoiding stocks where there's likely to be disappointment relative to current expectations.
Unsurprisingly, the best opportunities still reside in sectors that have been the most shut down over the past year. Areas like consumer and business services, travel and leisure, to name a few. It's also in sectors that are likely to benefit from higher interest rates or inflation, like banks, materials and energy. Small caps look a bit extended to us at the moment, and they could be vulnerable to higher interest rates, so we'd be a bit more inclined to add here on a further pullback.
The areas that appear most vulnerable to higher interest rates remain expensive growth stocks that have limited profitability at the moment. We're also wary of companies that may have experienced excess demand last year. This would include certain essential businesses that remained open during the pandemic and companies that produce goods and services required to work from home or provide entertainment during the lockdown.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.