Our CIO and Chief U.S. Equity Strategist says that while equity
market activity suggests a measured level of optimism about 2025,
the questions around tariffs and inflation have tempered
expectations.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief US Equity Strategist. Today on the
podcast I will be discussing how equity markets have traded post
the election and how this fits with our thinking.
It's Tuesday, Dec 10 at 11:30am in New York. So let’s get after
it.
Post the election, our focus has been on the potential for a
rebound in animal spirits like we observed following the
2016 election. During that historical period, we saw a
broad-based surge in corporate, consumer and investor confidence
as the sentiment analysis we’ve done shows. So far over the last
month, sentiment data has reflected a more measured level of
optimism led by small business confidence while services related
business outlooks were actually tempered somewhat.
Our assessment of the details of these surveys and commentary
from corporates suggests that consumers and companies are feeling
more optimistic heading into 2025. But the uncertainty around
tariffs and the still elevated price levels are likely holding
back the type of exuberance we saw post the 2016 election.
In 2016, we were also coming out of an industrial/manufacturing
downturn, which was then aided by aggressive China stimulus. Due
to that downturn, interest rates were much lower globally and
sovereign deficits and balance sheets were in much better shape
to absorb reflationary type policies like tax cuts and
deregulation. As a result, the equity market almost immediately
embraced an expansionary fiscal agenda that was interpreted as
being pro-growth. Today, that policy agenda appears to be less
front-footed in this regard, perhaps due to some of these
constraints.
Nevertheless, these dynamics are still supportive of our
preference for more cyclical sectors. However, given the
stickiness of interest rates, it also makes sense to remain up
the quality curve within cyclicals and constructively focused on
sectors with clearer de-regulation tailwinds. As a result,
Financials remain our preferred over-weight, followed by
Software, Utilities and Industrials.
On the topic of interest rates, we find it interesting that the
correlation of S&P 500 returns versus the change in bond
yields remains in positive territory. In other words, good macro
data is good for equity returns. Furthermore, there is a clear
bifurcation in terms of this correlation between cyclical
and defensive sectors. Cyclical sectors are showing a positive
correlation to rates, with one exception of Materials, while
defensive cohorts are showing a negative correlation except for
Utilities.
In our view, this is a sign that cyclicals and the market overall
still like stronger macro data even if it comes amid higher
yields. Having said that, there is a point where this dynamic
would likely reverse if interest rates rise due to less
dovish monetary policy or an increase in the term premium.
In April of this year, that level was 4.5 per cent on the 10-year
Treasury yield when growth and inflation drove the term
premium higher. For now, rates remain contained well below that
threshold and the term premium is close to zero.
On the flipside, a material decline in yields due to weakness in
the macro growth data would also hurt cyclical stocks
disproportionately leaving 4.00-4.50 per cent on the 10-year
treasury yield as the sweet spot for equity valuations. Yields
below that range can certainly be tolerated by equities assuming
the driver is Fed rate cuts in the absence of a material slowdown
in growth. Yields above that range can also be tolerated if the
pace of the rate rise is measured, and the driver is stronger
nominal growth versus a more hawkish Fed or a rising
inflation.
Finally, as we approach year-end, December seasonality is likely
to be a focal point for investors. Over the past 45 years,
the S&P 500's median return over the month of December is 1.5
per cent and the index has a positive return 73 per cent of the
time. Notably, almost all of that performance comes in the second
half of the month. These trends are directionally consistent for
the Russell 2000 small cap index except that it’s even stronger
at about 2.5 per cent. This performance could be further enhanced
by the larger post-election spike in small business confidence
mentioned earlier.
Thanks for listening. If you enjoy the podcast, leave us a review
wherever you listen, and share Thoughts on the Market with a
friend or colleague today.
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