Year-to-date macroeconomic data has shown signs of weakness, leading to weakness in low-quality, economically sensitive market sectors, while a narrow group of large-cap stocks have driven performance.
According to strategists at Morgan Stanley, this indicates that the market “is becoming more focused on slowing growth and less focused on inflation and interest rates.”
“The poor performance of small caps despite low interest rates is a good example of this phenomenon,” the strategists wrote.
“This backdrop coincides with our long-standing view that the current policy mix of heavy fiscal and high interest rates is effectively crowding out many economic participants,” they added.
Unless there is a significant shift in the macro picture, Morgan Stanley believes high-quality, large-cap stocks will continue to drive outperformance. The Wall Street giant sees three potential catalysts for such a shift.
Primarily, accelerating inflation and growth could prompt the Fed to reconsider raising interest rates, however, strategists at Morgan Stanley point out that this appears unlikely and is priced in at the lower end in the markets. If that happens, it could extend the equity rally to lagging sectors such as small caps and regional banks, although rising interest rates could weigh on valuations of large companies.
Moreover, deteriorating liquidity could lead to capital outflows, especially if government deficit financing becomes a concern.
“A good way to monitor this risk is with the premium term, which stays near zero,” the strategists said. “If this changes, and the premium rises like last fall, we would expect a broad decline in stocks, with a few stocks performing well.”
They added that liquidity provisions currently mitigate these risks.
Finally, greater fear of growth may negatively impact stock multiples across the board. In this scenario, quality large caps may outperform moderately, but defensive stocks are likely to fare better.
Under current conditions, strategists continue to recommend a consistent approach, balancing large-cap quality growth with defenses. On the other hand, they advise against investing in low-quality cyclical stocks and warn against the temptation to expect a broad market rally.