Morgan Stanley chief U.S. equity strategist and chief investment officer Michael Wilson’s perspective is 180 degrees different than the strategy team at BofA Securities. Whereas BofA believes we are in the beginning stages of a new market cycle and the equity market rally is far from over, and that narrow market leadership is not indicative of a bubble, Morgan Stanley believes we are dealing with the last gasp of the previous market cycle.
Mr. Wilson highlights three major risks for U.S. equity markets in the weeks ahead which, combined with average valuation levels in the top decile relative to history, could lead to a “meaningful correction.”
The first risk is that economic growth accelerates strongly enough that the Federal Reserve has to consider more interest rate hikes. This growth would likely be accompanied by a broadening of market leadership into small caps, transports, and lower-quality consumer cyclicals before the Fed started making hawkish noises. Mr. Wilson considers this scenario, which sounds similar to BofA Securities equity and quant strategist Savita Subramanian’s base case, as unlikely.
The second risk is a withdrawal of liquidity in equity markets that sends stock prices lower. The U.S. government is running a giant budget deficit, even by their standards. Mr. Wilson is concerned that the bond issuance necessary to fund the deficit will cause longer-term bond yields to climb, attracting investment capital away from stocks.
The third market risk, a sharp downturn in U.S. economic growth, is deemed most likely by Morgan Stanley. The U.S. economic surprise index, which measures economic data relative to economists’ expectations (and can be followed here), made a new one-year low last week, indicating ongoing data disappointments.
These two opposing forecasts make my life easier. Without believing either one, they provide indicators that act as road signs for the future direction of markets. If, for example, small-cap stocks and trucking companies start leading the market, BofA and Ms. Subramanian are likely to have the more accurate investment advice. On the other hand, further declines in the U.S. economic surprise index will point towards Mr. Wilson’s more dour forecast.
-- Scott Barlow, Globe and Mail market strategist
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