Finding Opportunity in an Uncertain U.S. Equity Market

Summary

Thoughts on the Market: Finding Opportunity in an Uncertain U.S. Equity Market

Hosted by Morgan Stanley, this episode of "Thoughts on the Market" delves into the current dynamics shaping the U.S. equity landscape. Morgan Stanley’s Chief U.S. Equity Strategist, Mike Wilson, provides an insightful analysis of market trends, interest rate impacts, sector performance, and macroeconomic factors influencing investor strategies.

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1. Market Performance Overview

Mike Wilson opens the discussion by highlighting the stagnation of the S&P 500 since early December. The index, which had enjoyed a robust run during the summer, has seen its momentum slow due to several factors, with the most significant being the rise in 10-year Treasury yields.

“Since early December, The S&P 500 has made little headway. The almost unimpeded run from the summer was halted by a few things, but none as important as the rise in 10-year treasury yields, in my view.”
— Mike Wilson, 00:40

2. Impact of Rising Treasury Yields on Equity Valuations

Wilson emphasizes the critical role of Treasury yields in equity valuations. In December, a yield of 4 to 4.5% was identified as the optimal range for equity multiples, presuming steady growth and earnings. However, the Federal Reserve's less dovish stance led to yields surpassing the 4.5% threshold, solidifying a negative correlation between stocks and yields.

“Yields are no longer supportive of higher valuations, a key driver of returns the past few years. Instead, earnings are now the primary driver of returns, and that is likely to remain the case for the foreseeable future.”
— Mike Wilson, 02:15

3. Shift from Yield-Driven to Earnings-Driven Returns

With the Fed's stance becoming less accommodative and uncertainties surrounding tariffs and inflation data further influencing market dynamics, Wilson notes a pivotal shift. The bond market now anticipates only one rate cut for the remainder of the year, contingent on inflation and growth data outcomes.

“Our strategy has shifted too. With the S&P 500 reaching our tactical target of 6,100 in December and earnings revision breadth now rolling over for the index, we have been more focused on sectors and factors.”
— Mike Wilson, 03:00

4. Sector and Factor-Based Investment Strategies

In response to the changing market conditions, Morgan Stanley has pivoted toward a more selective approach, emphasizing sectors and factors demonstrating robust earnings revisions. The favored sectors include:

• Financials
• Media and Entertainment
• Software (over semiconductors)
• Consumer Services (over consumer goods)

Within defensive sectors, Wilson prefers:

• Utilities (over staples)
• REITs
• Healthcare

“On that score, we continue to favor earnings revision, breadth, quality and size factors alongside financials, software, media and entertainment and consumer services at the industry level.”
— Mike Wilson, 04:30

5. Macro Developments Influencing Equity Markets

Wilson addresses several macroeconomic factors that are currently shaping the equity markets:

• Policy Announcements: Active initiatives from the White House, including tariffs and immigration enforcement, are creating idiosyncratic impacts on the market.

• Tariffs: If tariffs on China, Mexico, and Canada are sustained through 2026, the S&P 500 could see an earnings per share (EPS) reduction of approximately 5 to 7%.

“Industries facing greater headwinds from China tariffs include consumer discretionary goods and electronics.”
— Mike Wilson, 05:30

• Immigration: Lower immigration flows are expected to impact aggregate demand more significantly than wage costs for public companies.

6. Fiscal Policy and Federal Spending Cuts

Discussing the Department of Government Efficiency's efforts to reduce federal spending, Wilson expresses skepticism about the feasibility of meaningful cuts. He remains cautiously optimistic but acknowledges that successful reductions could initially hinder growth before offering long-term benefits such as lower fiscal deficits and reduced crowding out of the private sector.

“Skepticism remains high as it relates to doge's ability to cut federal spending meaningfully. I remain more optimistic on that front, but realize greater success also presents a headwind to growth before it provides a tailwind via lower fiscal deficits and less crowding out of the private economy.”
— Mike Wilson, 06:45

7. Conclusion: Strategic Focus Amid Market Cap Constraints

Wilson concludes by summarizing the current market landscape characterized by higher long-term rates and growth headwinds from a stronger dollar. These factors have constrained equity multiples, making sector and factor selection crucial for performance rather than merely increasing portfolio beta.

“Bottom line, higher back end rates and growth headwinds from the stronger dollar. And the initial policy changes suggest equity multiples are capped for now. That means stock factor and sector selection remains key to performance rather than simply adding beta to one's portfolio.”
— Mike Wilson, 07:30

Final Insights:

Morgan Stanley advises investors to maintain a strategic focus on sectors and factors that exhibit strong earnings revisions and resilience amidst macroeconomic uncertainties. By prioritizing quality and size factors, along with selected industry exposures, investors can navigate the complexities of an uncertain U.S. equity market.

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For more insights and detailed analyses, tune into future episodes of "Thoughts on the Market." Share your thoughts and support initiatives like Feeding America by participating in the listener survey linked in the show notes.

Transcript

[A]

Hi, I'm Andrew Sheats, Head of Corporate Credit Research at Morgan Stanley. Before we get to today's episode, the team behind Thoughts of the Market wants your thoughts and your input. Fill out our listener survey and help us make this podcast even more valuable to you. The link is in the show Notes plus Help us help the Feeding America organization. For every survey completed, Morgan Stanley will donate $25 towards their important work. Thanks for your time and the support onto the show.

[B]

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and chief U.S. equity strategist. Today on the podcast, I'll be discussing equities in the context of higher rates and weaker earnings revisions. It's Tuesday, February 18th at 11:30am in New York, so let's get after it. Since early December, The S&P 500 has made little headway. The almost unimpeded run from the summer was halted by a few things, but none as important as the rise in 10 year treasury yields, in my view. In December, we cited 4 to 4.5% as the sweet spot for equity multiples, assuming growth and earnings remained on Track. We viewed 4.5% as a key level for equity valuations. And sure enough, when the Fed leaned less dovish at its December meeting, Yields crossed that 4.5% threshold and correlations between stocks and yields settled firmly in negative territory where they remain. In other words, yields are no longer supportive of higher valuations, a key driver of returns the past few years. Instead, earnings are now the primary driver of returns, and that is likely to remain the case for the foreseeable future. While the Fed was already increasingly less dovish, the uncertainty on tariffs and last week's inflation data could further that shift. With the bond market moving to just one cut for the rest of the year, our official call is in line with that view. With our economists now looking for just one cut in June, it depends on how the inflation and growth data roll in. Our strategy has shifted too. With the S&P 500 reaching our tactical target of 6,100 in December and earnings revision breadth now rolling over for the index, we have been more focused on sectors and factors. In particular, we favored areas of the market showing strong earnings revisions on an absolute or or relative basis. Financials, media, entertainment, software over semiconductors and consumer services over goods continue to fit that bill. Within defenses, we have favored utilities over staples, REITs and healthcare. While we've seen outperformance in all these trades, we're sticking with them for now. We maintain an overriding preference for large cap quality unless 10 year treasury yields fall sustainably below 4.5% without a meaningful degradation in growth. The key component of 10 year yields to watch for equity valuations remains the term premium, which has come down but is still elevated compared to the past few years. Other macro developments driving stock prices include the very active policy announcements from the White House, including tariffs, immigration enforcement and cost cutting efforts by the Department of Government Efficiency, also known as doge for tariffs. We believe that will be more of an idiosyncratic event for equity markets. However, if tariffs were to be imposed and maintained on China, Mexico and Canada through 2026, the impact to earnings per share would be roughly 5 to 7% for the S&P 500. That's not an insignificant reduction and likely one of the reasons why guidance this past quarter was more muted than fourth quarter results. Industries facing greater headwinds from China tariffs include consumer discretionary goods and electronics. Lower immigration flow and stock is more likely to affect aggregate demand than to be a wage cost headwind, at least for public companies. Finally, skepticism remains high as it relates to doge's ability to cut federal spending meaningfully. I remain more optimistic on that front, but realize greater success also presents a headwind to growth before it provides a tailwind via lower fiscal deficits and less crowding out of the private economy, things that could lead to more Fed cuts and lower long term interest rates as term premium falls. Bottom line, higher back end rates and growth headwinds from the stronger dollar. And the initial policy changes suggest equity multiples are capped for now. That means stock factor and sector selection remains key to performance rather than simply adding beta to one's portfolio. On that score, we continue to favor earnings revision, breadth, quality and size factors alongside financials, software, media and entertainment and consumer services at the industry level. Thanks for listening. If you enjoy the podcast, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.

[C]

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