Thoughts on the Market: How Equity Markets Are Feeling About 2025
Podcast Information:
- Title: Thoughts on the Market
- Host/Author: Morgan Stanley
- Episode: How Equity Markets Are Feeling About 2025
- Release Date: December 10, 2024
Morgan Stanley's podcast, "Thoughts on the Market," offers insightful analyses on recent market events through various perspectives within the firm. In the December 10, 2024 episode titled "How Equity Markets Are Feeling About 2025," Mike Wilson, Morgan Stanley's Chief Investment Officer (CIO) and Chief U.S. Equity Strategist, delves deep into the current state of equity markets post-election and projects future trends leading up to 2025.
1. Post-Election Market Sentiment and Comparison to 2016
Rebound in Animal Spirits: Mike Wilson opens the discussion by reflecting on the market's behavior following the recent election. He draws a parallel to the post-2016 election period, where there was a notable surge in corporate, consumer, and investor confidence.
"Post the election, our focus has been on the potential for a rebound in animal spirits like we observed following the 2016 election." [00:00]
Measured Optimism: However, unlike 2016, the current sentiment is more tempered. Sentiment analysis over the past month indicates a balanced level of optimism, predominantly driven by small business confidence. Conversely, businesses in the services sector exhibit a more cautious outlook.
"Over the last month, sentiment data has reflected a more measured level of optimism led by small business confidence, while services related businesses outlooks were actually tempered somewhat." [00:00]
Factors Influencing Current Sentiment: Consumers and companies are optimistic about the outlook towards 2025, yet uncertainties linger due to tariffs and persistently high price levels. These factors are dampening the exuberance that characterized the post-2016 period.
"Consumers and companies are feeling more optimistic heading into 2025, but the uncertainty around tariffs and the still elevated price levels are likely holding back the type of exuberance we saw post the 2016 election." [00:00]
2. Economic Conditions: Then and Now
2016 vs. 2024 Economic Landscape: Wilson contrasts the current economic environment with that of 2016. In 2016, the end of an industrial manufacturing downturn, aggressive China stimulus, lower global interest rates, and robust sovereign balance sheets created a conducive environment for expansionary fiscal policies like tax cuts and deregulation. These policies were perceived as pro-growth, leading to an immediate and positive reception in the equity markets.
"In 2016 we were also coming out of an industrial manufacturing downturn, which was then aided by aggressive China stimulus... the equity market almost immediately embraced an expansionary fiscal agenda that was interpreted as being pro growth." [00:00]
Current Constraints: Contrastingly, today's policy agenda is less aggressive in its growth orientation, likely due to elevated interest rates and other economic constraints. Despite these challenges, Wilson remains optimistic about cyclical sectors, particularly those benefiting from deregulation.
"Today, that policy agenda appears to be less front footed in this regard, perhaps due to some of these constraints... our preference for more cyclical sectors." [00:00]
3. Sector Preferences and Strategy
Cyclical Sectors Focus: Given the current economic dynamics, Morgan Stanley favors cyclical sectors. However, with the persistence of higher interest rates, there's a strategic tilt towards higher quality within cyclicals. Sectors with clear deregulation tailwinds are particularly attractive.
"Given the stickiness of interest rates, it also makes sense to remain up the quality curve within cyclicals and constructively focused on sectors with clearer deregulation tailwinds." [00:00]
Top Preferred Sectors:
- Financials: Maintained as the top overweight sector.
- Software: Followed closely due to growth prospects.
- Utilities and Industrials: Also favored for their resilience and growth potential.
"As a result, financials remain our preferred overweight, followed by software, utilities and industrials." [00:00]
4. Interest Rates and Equity Correlation
Positive Correlation with S&P 500: Wilson highlights an intriguing trend where the S&P 500 returns positively correlate with changes in bond yields. This indicates that robust macroeconomic data tends to boost equity returns.
"We find it interesting that the correlation of S&P 500 returns versus the change in bond yields remains in positive territory. In other words, good macro data is good for equity returns." [00:00]
Cyclical vs. Defensive Sectors: A clear divide exists between cyclicals and defensive sectors regarding their response to interest rates:
- Cyclical Sectors: Generally show a positive correlation with rising rates, with the exception of materials.
- Defensive Sectors: Typically exhibit a negative correlation with rising rates, except for utilities.
"There is a clear bifurcation in terms of this correlation between cyclical and defensive sectors. Cyclical sectors are showing a positive correlation to rates with one exception of materials, while defensive cohorts are showing a negative correlation except for utilities." [00:00]
Implications for Market Dynamics: Cyclicals remain favorable as long as macroeconomic data remains strong, even in the face of higher yields. However, if interest rates continue to rise due to tighter monetary policies or an increase in the term premium, this dynamic could shift. Conversely, a significant drop in yields driven by weakened macro growth could adversely impact cyclical stocks.
"In our view, this is a sign that cyclicals in the market overall still like stronger macro data, even if it comes amid higher yields... a sweet spot for equity valuations." [00:00]
Thresholds for Treasury Yields: Wilson identifies the 10-year treasury yield range of 4% to 4.5% as optimal for equity valuations. Rates below this range are acceptable, provided they're driven by Federal Reserve rate cuts without a significant slowdown in growth. Rates above this range are tolerable if the increase is gradual and fueled by robust nominal growth rather than aggressive monetary tightening.
"Leaving 4 to 4.5% on a 10 year treasury yield as a sweet spot for equity valuations... assuming the driver is Fed rate cuts in the absence of a material slowdown in growth." [00:00]
5. December Seasonality and Year-End Trends
Historical Performance: December historically exhibits positive seasonality in the markets. The S&P 500 has a median return of 1.5% in December, achieving positive returns 73% of the time. Notably, the majority of this performance emerges in the latter half of the month.
"As we approach year end, December seasonality is likely to be a focal point... The S&P 500's median return over the month of December is 1.5% and the index has a positive return 73% of the time. Notably, almost all of that performance comes in the second half of the month." [00:00]
Small Cap Advantage: The Russell 2000 Small Cap Index mirrors these trends but with even stronger performance, averaging approximately 2.5% returns in December. This strength is further supported by the earlier-mentioned increase in small business confidence post-election.
"These trends are directionally consistent for the Russell 2000 Small Cap Index, except that it's even stronger at about 2.5%. This performance could be further enhanced by the larger post election spike in small business confidence mentioned earlier." [00:00]
Conclusion and Strategic Takeaways
Mike Wilson concludes the episode by reinforcing Morgan Stanley's strategic preferences in the current market environment. Emphasis is placed on cyclical sectors with high quality and clear growth catalysts, notably financials, software, utilities, and industrials. Additionally, understanding the interplay between interest rates and sector performance is crucial for navigating the equity landscape towards 2025. December's historically positive trend provides an additional layer of optimism for year-end market performance.
Listeners are encouraged to stay informed and consider the outlined strategies when evaluating their investment portfolios.
Notable Disclaimer:
"The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for." [04:21]
About the Host: Mike Wilson, as Morgan Stanley's CIO and Chief U.S. Equity Strategist, brings a wealth of expertise in guiding equity strategies and market insights. His analyses provide valuable perspectives for investors navigating the complexities of the financial markets.
For more insightful discussions and market analyses, tune into "Thoughts on the Market" and stay ahead with Morgan Stanley's expert perspectives.