The warning signs investors like you shouldn’t ignore

• Stock investors seem to be shrugging off the recession concerns reflected in today’s bond markets.
• Weakening business sentiment suggests corporate earnings are at risk.
• Investors should be patient and look for income opportunities in stocks and bonds.

US stock and bond investors haven’t seen eye-to-eye lately.

Equity investors seem to have largely shrugged off concerns about monetary policy and the US economy. In the past week alone, the Cboe Volatility Index (VIX), which functions as the stock market’s “fear gauge,” fell to its lowest levels in 17 months. The S&P 500 Index has gained about 5% over the past month and is just shy of its January 2023 high.

On the other hand, Treasury bonds have continued to reflect recession risks. Bond-market volatility has soared. And recent Treasury yield movements imply a high probability of recession in the next 12 months.

Should investors buy into the equity market’s optimism or heed the cautionary signals in the bond market?

Morgan Stanley’s Global Investment Committee believes now is a time for investors to take caution.

With forecasts suggesting 12% profit growth in 2024, investors seem to hope that earnings growth would resume its upward trajectory. However, the rapid deterioration in metrics around small and medium-sized businesses offers a more sobering outlook.

In fact, recent surveys by the National Federation of Independent Business (historically strong leading indicators of S&P 500 earnings) show a marked decline in business sentiment, reaching a 40-year low in the share of respondents saying that “now is a good time to expand.”  Demand and pricing power indicators also fell alongside weakness in wage expectations and hiring intentions, which usually portends a rise in unemployment claims. 

Although there is greater financial liquidity today than in the average of the last 40 years, these conditions could recede. Here’s why:

• Recent banking turmoil suggests that severe credit contractions are coming, with regional banks’ year-over-year deposit and credit growth having already turned negative.
• The federal debt-ceiling debate is starting to take shape in earnest, and rhetoric from a deeply divided Congress may have a destabilizing effect on financial markets. However, we fully expect Congress to lift the borrowing limit.
• A wave of Treasury issuance may ensue once Congress ultimately agrees to raise the debt ceiling. This could drain the financial system of $650­ billion to $750 billion in the second half of this year.

With business conditions worsening and financial conditions apt to tighten, equity investors’ recent optimism may be misplaced. We may see a reckoning take place between the stock and bond narrative in the next three to six months.

For now, investors may want to wait out uncertainties around policy, recession risks and corporate earnings. We prefer the risk/reward profile of high-quality fixed-income investments and believe investors should focus on income opportunities in both stocks and bonds, avoiding stock market indices like the S&P 500 that over-weight or favor larger companies.

The source of this article, “The Warning Signs Investors Should Not Ignore” was originally published on April 26, 2023.