Our CIO and Chief U.S. Equity Strategy Mike Wilson suggests that
stock, factor and sector selection remain key to portfolio
performance.
----- 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’ll be discussing equities in the context of higher
rates and weaker earnings revisions.
It's Tuesday, Feb 18th at 11:30am in New
York.
So let’s get after it.
Since early December, the S&P 500 has made little headway.
The almost unimpeded run from the summer was halted by a few
things but none as important as the rise in 10-year Treasury
yields, in my view. In December, we cited 4 to
4.5 percent as the sweet spot for equity multiples
assuming growth and earnings remained on track. We viewed
4.5 percent as a key level for equity
valuations. And sure enough, when the Fed leaned less dovish
at its December meeting, yields crossed
that 4.5 percent threshold; and correlations
between stocks and yields settled firmly in negative territory,
where they remain. In other words, yields are no longer
supportive of higher valuations—a key driver of returns the past
few years.
Instead, earnings are now the primary driver of returns and that
is likely to remain the case for the foreseeable future. While
the Fed was already increasingly less dovish, the uncertainty on
tariffs and last week’s inflation data could further that shift
with the bond market moving to just one cut for the rest of the
year. Our official call is in line with that view with our
economists now just looking for just one cut–in June. It
depends on how the inflation and growth data roll in.
Our strategy has shifted, too. With the S&P 500 reaching our
tactical target of 6100 in December and earnings revision breadth
now rolling over for the index, we have been more focused on
sectors and factors. In particular, we’ve favored areas of the
market showing strong earnings revisions on an absolute or
relative basis.
Financials, Media and Entertainment, Software over Semiconductors
and Consumer Services over Goods continue to fit that bill.
Within Defensives, we have favored Utilities over Staples,
REITs and Healthcare. While we’ve seen outperformance in all
these trades, we are sticking with them, for now. We maintain an
overriding preference for Large-cap quality unless
10-year Treasury yields fall sustainably below
4.5 percent without a meaningful degradation in
growth. The key component of 10-year yields to watch for equity
valuations remains the term premium – which has come
down, but is still elevated compared to the past few
years.
Other macro developments driving stock prices include the very
active policy announcements from the White House including
tariffs, immigration enforcement, and cost cutting efforts by
the Department of Government Efficiency, also
known as DOGE. For tariffs, we
believe they will be more of an idiosyncratic event for
equity markets. However, if tariffs were to be imposed and
maintained on China, Mexico and Canada through 2026, the impact
to earnings-per-share would be roughly
5-7 percent for the S&P 500. That’s not an
insignificant reduction and likely one of the reasons why
guidance this past quarter was more muted than fourth
quarter results.
Industries facing greater headwinds from China tariffs include
consumer discretionary goods and electronics. Lower immigration
flow and stock is more likely to affect aggregate demand
than to be a wage cost headwind, at least for public companies.
Finally, skepticism remains high as it relates to DOGE’s ability
to cut Federal spending meaningfully. I remain more optimistic on
that front, but realize greater success also presents a headwind
to growth before it provides a tailwind via lower fiscal deficits
and less crowding out of the private economy—things that could
lead to more Fed cuts and lower
long-term interest rates as term premium falls.
Bottom line, higher backend rates and growth headwinds
from the stronger dollar and the initial policy changes suggest
equity multiples are capped for now. That means stock, factor and
sector selection remains key to performance rather than simply
adding beta to one’s portfolio. On that score, we continue
to favor earnings revision breadth, quality, and size factors
alongside financials, software, media/entertainment and
consumer services at the industry level.
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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