Why stocks’ rally could keep slowing down

• With inflation-adjusted rates on 10-year Treasuries around 2%, today’s lofty stock valuations could prove unsustainable.
• Deteriorating growth in China and a mixed economic picture in the US may be a further a drag on stock performance.
• Some investors are  balancing equity exposure between offense and defense, with a focus on quality.

The US stock market rally seems to have taken a pause after the year’s rapid gains. The S&P 500 Index and Nasdaq are down 4% and 6%, respectively, from their year-to-date highs in July. Bullish investors may chalk it up to the summer doldrums, with August typically being a sluggish time for US equities. But Morgan Stanley’s Global Investment Committee (GIC) believes those bullish investors are being complacent and, looking ahead, may need a reality check about three risks to today’s markets and economy:

1. “Real,” or inflation-adjusted, Treasury rates have surged, which could pressure stock valuations.
   Notably, the real rate on 10-year Treasury bonds rose above 2.0% last week, its highest since the 2008 financial crisis. Why does that matter? The 10-year yield on Treasuries is the fundamental “risk-free” benchmark rate that underpins the way some investors value most asset classes. If investors can get higher yields from a low-risk investment such as Treasuries, they have less incentive to take on greater risk from investments such as equities. In addition, higher yields lower the value of stocks’ future earnings in widely used pricing models. This means the average S&P 500 company’s lofty price/earnings multiple of about 20 may not be sustainable, given that real rates of 1.5%-2.0% have historically been correlated with ratios closer to 17.
   
   Some investors may be hoping the recent rise in rates is temporary, but the GIC believes it could reflect durable factors. These include structurally higher US deficits, which could increase government borrowing costs, as well as policy uncertainty as the Federal Reserve may keep rates higher for longer than previously expected.
2. China’s deteriorating economic growth may weigh on the global economy and US multinational companies. 
   China appears to be suffering a crisis of confidence. Although households have ample excess savings, the economy is seeing limited demand as consumers worry about record-high youth unemployment—above 20%—and falling home prices. Inconsistent policy, which has vilified tech entrepreneurs at times, hasn’t helped boost the spirits of private enterprise either. Given China’s considerable influence on global trade and consumption, the country’s malaise could spill over into the broader world economy, especially other emerging-market countries and Europe.
3. US economic data continues to be mixed. 
   July delivered some better-than-expected results, including data on industrial production and retail sales. These developments helped drive the Atlanta Fed to forecast an eye-popping 5.9% Gross Domestic Product (GDP) growth for the third quarter. But those positive surprises don’t tell the whole story. Both manufacturing and services data look to be weakening, while leading indicators and yield curves continue to signal caution. Consumer credit data is worsening, and the October resumption of student loan payments looms as households continue to draw down their excess savings.

All told, the GIC believes some investors may not be out of the woods yet.

For some investors, this could be the time for active risk management, not complacency. With stock indices likely to stay close to their current range over the next few quarters, according to the GIC, some investors are making sure their portfolios are not too heavily weighted in any  specific sector, and are balancing equity exposure between offense and defense, with a focus on quality.

Some investors may also be using losses in municipal bonds, preferred securities, and Treasuries to offset taxes on gains from other asset classes and rebalance toward intermediate duration in fixed income.

The source of this article, Why Stocks’ Rally Could Keep Slowing Down, was originally published on  August 29, 2023.