Is the US economy poised for a comeback?

• June’s cooler-than-expected inflation reading is bolstering investors’ confidence in a rebound for the US economy and corporate profits in 2024.
• Strength in the US labor market, housing sector, and corporate investment could help spur renewed economic growth.
• In this environment, investors should look for opportunities in commodities and industrials, energy, housing, financials, and healthcare stocks.

The latest consumer price index data showed US inflation has eased to 3%, the slowest pace in more than two years. The cooler-than-expected reading seems to be allaying investors’ concerns about the Federal Reserve’s rate hikes and bolstering their confidence in a re-acceleration of economic growth and a strong rebound in corporate profits in 2024.

Indeed, market-based forecasts suggest S&P 500 company earnings will advance at least 10% next year to a new high, which would be 48% greater than their 2019 levels. Stock prices continue to move higher, now reflecting a forward price-earnings ratio of nearly 20. To many investors, these dynamics no longer illustrate an economy that might muddle through a “soft landing,”—an economic slowdown that avoids recession—but one that may be set for an expansion.

Morgan Stanley’s Global Investment Committee has long been skeptical of such a sanguine outlook. We have maintained that company profitability is likely to get worse before it gets better, given factors such as decelerating real economic activity, weak new orders, diminishing pricing power, and lagging impacts of higher interest rates.

• A strong labor market: Unemployment, currently at 3.6%, is near 50-year lows, and for every unemployed person, there are about 1.6 job openings, compared with a 15-year average through May 2023 of fewer than 0.5. With price pressures easing, personal incomes may see some gains, when adjusted for inflation, for the first time in this business cycle. Not all of those income gains may go to spending, as individuals may decide to save more or pay off debt, but ultimately a stable jobs market should prevent a collapse in consumption, which accounts for about two-thirds of US GDP.
• A tight housing market: Despite higher mortgage rates and sluggish activity in existing home sales, household formation is outpacing home availability, putting a floor under overall home prices and activity. These supply-demand dynamics may help prevent material weakening in housing, which is a major, rate-sensitive part of the economy.
• Resurgent capital spending: Positive drivers of capital investment today include strong corporate balance sheets, productivity-boosting enterprise technologies, and fiscal spending programs focused on decarbonization and realignment of global supply chains—all with the potential to spur renewed economic growth.

With these factors at play, the economy may indeed re-accelerate. If it does, the stock market is likely to feature a new set of winners, with today’s high-flying consumer-tech and media names giving way to leaders from other equity sectors, such as industrials, energy, housing, financials, and healthcare, as well as commodities.

In the spirit of “skating to where the puck is going, not where it has already been,” investors should consider trimming passive index-level exposures to US stocks and rebalancing toward the above-mentioned sectors that are better aligned with a resilient economy.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 17, 2023, A New Narrative: Reflation.