According to Morgan Stanley, the path to a “Goldilocks” scenario – a state of economic equilibrium characterized by moderate growth and low inflation – is becoming increasingly difficult.
The central bank’s latest note highlighted the market’s reaction to the Fed’s likely start of rate cuts in September, driven by a marked slowdown in inflation in June, which caused a significant decline in US Treasury yields and a rotation in stocks’ leadership.
The Standard & Poor’s 500 index, which peaked at an all-time high of 5,667 points, fell 3%, while the Nasdaq Composite Index, which is heavily weighted by large-cap technology stocks, fell twice that amount, the bank said.
In contrast, the Russell 2000 index of small-cap stocks gained more than 10%. This shift also saw value stocks outperform growth stocks, cyclicals outperform defensive stocks, and low-quality stocks outperform high-quality stocks.
Importantly, more than 80% of stocks were above their 200-day moving average, indicating growing confidence in a soft landing scenario for the economy.
Despite this optimism, Morgan Stanley noted that economic surprises were mixed, and that earnings season showed limited positive surprises, with forecasts reflecting negative revisions and skepticism about returns on AI-generated investments. They note that this suggests that market movements revolve almost exclusively around valuation multiples and price expectations.
Morgan Stanley’s global investment committee remains cautious, acknowledging that while a soft landing is its base case, the narrow path to that scenario is fraught with challenges.
They point out that American consumers are increasingly dependent on jobs for consumption, that corporate management teams are facing aggressive expectations for expanding profit margins, and that global growth is slowing as policy uncertainty grows. Given these factors, the likelihood of a Fed mistake is thought to remain high.
Morgan Stanley advises focusing on asset class diversification, valuation, and growth at a reasonable price among stocks. It recommends favoring the equal-weighted S&P 500 or actively selecting cyclical or high-quality defensive stocks, while avoiding the temptation to chase the momentum of small-cap stocks or the boom of the Big Seven.