2021 Midyear investor outlook: A tricky transition
Insights from Morgan Stanley Research06/17/21
Strong economic winds may call for charting a different course, including looking for opportunities globally, focusing on out-of-favor sectors, and investing thematically.
In a little more than a year, the global economy has rebounded from one of the worst recessions on record to growth that likely will surpass its pre-pandemic trajectory. The recovery has also benefited from unprecedented conditions, including massive fiscal stimulus and monetary easing, as well as the highest consumer savings rates in history—and now, the potential for a significant business investment cycle.
If the macroeconomic outlook seems clear, mapping an investment approach for what Morgan Stanley strategists call a “hotter and shorter" midcycle transition may be anything but straightforward, as investors consider potential inflation, policy changes, and higher corporate taxes.
“Although challenging, these problems are not insurmountable," says Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.
However, they may call for charting a different course. Here are four ideas for navigating the midcycle transition.
1. A hard look at US equity exposure
Following the initial excitement of recovery, the transition to midcycle typically means that higher rates and less dramatic improvements engage in a tug-of-war with earnings and valuations. The current market checks the boxes on the midcycle transition for every key indicator, save one—historically lower valuations. “Midcycle transitions commonly see stock prices decline between 10% to 20%," says Morgan Stanley Chief US Equity Strategist Mike Wilson.
As a result, Morgan Stanley strategists believe that a broader market correction may be overdue. The team’s contrarian view is based in part on the Federal Reserve’s commitment to “lower for longer” interest rates, giving US equities more room to run. “We do not doubt the Fed's resolve in that regard, but we think it means more tightening later," says Wilson, adding that investors are likely to price this in earlier, rather than later, in the cycle.
2. Favor reflation over reopening
Despite a more cautious stance on US equities overall, Morgan Stanley strategists believe that sectors that stand to benefit from reflation may offer more upside than those tied to reopening. For example, price-to-earnings multiples for consumer discretionary stocks recently traded significantly higher than their historical ratio. Bank stocks, in contrast, sit relatively near their historically low valuation levels and could benefit from improving macro conditions and potentially higher rates.
Likewise, valuations for health care stocks appear to be low relative to their historical levels thanks to lingering uncertainty around government policymaking. However, potential risks for policy are now largely known to the market and earnings may be set to improve. “We think a catch-up trade is very feasible," Wilson says.
3. Look for potential upside in Europe
Morgan Stanley strategists hold favorable views on Europe and, to a lesser extent, Japan. “Both regions have less inflationary pressure, less risk of changing tax or central bank policy and less expensive valuations," says Sheets.
European equities may stand to benefit from global reflation, given the region’s relatively early-stage recovery. Europe is also one of the few regions forecasted to post stronger GDP growth in 2022 than in 2021.
Plus, stocks are relatively inexpensive as investor attention appears to still be focused on other global equities markets.
4. Consider thematic outperformance
Thematic investment ideas, which include investing in economic, technological, and social trends, may be crucial, given the limited upside for major equity benchmarks. Many of these themes are global, span sectors and investment styles, and are supported by long-term secular shifts. Some examples include:
- Deglobalization: The dissociation between the US and China in key economic areas could impact global business strategy and the investment landscape. However, some industries, such as leisure and gaming, and global payments, may be well positioned for a slowdown, or even partial reversal of globalization.1
- Data era: A new computing cycle emerges every decade, increasing access to computing by a factor of 10. COVID-19 has accelerated the current cycle, which may present opportunities, not just for the tech sector, but also for advanced adopters, such as the manufacturing or health care sectors.
- Red-hot capital expenditure boom: An expected surge in corporate spending to ramp up growth is a pillar of Morgan Stanley's economic outlook, with implications beyond the usual suspects. This theme sits at the nexus of other big ideas, including data, decarbonization and deglobalization.
Bottom line: A tricky transitional period for the economy and markets requires diligence on the part of investors. Make sure any decisions reflect individual goals, timelines, and risk tolerance when charting the course ahead.
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