Macroeconomic data for the current year has shown signs of weakness, leading to lower activity in lower-quality and economically sensitive segments of the market, while a narrow selection of high-quality large-cap stocks led to higher performance.
According to strategists at Morgan Stanley, this suggests the market is “becoming more focused on slowing growth and less focused on inflation and rates.”
“The underperformance of small-caps despite falling rates is a good example of this phenomenon,” the strategists wrote.
“This backdrop is consistent with our long-standing view that current policies of fiscal austerity and higher rates are effectively crowding out many economic participants,” they added.
Barring significant changes in the macroeconomic picture, Morgan Stanley believes quality large-cap stocks will continue to outperform. The Wall Street giant sees three potential reasons for this change.
First, a reacceleration of inflation and economic growth could prompt the Fed to reconsider raising rates, but Morgan Stanley strategists note that this seems unlikely and is minimally priced in by markets. If that happens, it could spread equity gains to lagging sectors such as small caps and regional banks, although higher rates could weigh on large-cap valuations.
Moreover, deteriorating liquidity could lead to capital flight, especially if financing government deficits becomes a problem.
“A good way to monitor this risk is through the term premium, which remains close to zero,” the strategists said. “If the situation changes and the term premium rises as it did last fall, we expect a broad decline in equities, with few stocks outperforming.”
Currently, liquidity provisions mitigate this risk, they added.
Finally, significant concerns about economic growth could negatively impact stock multiples across the board. In this scenario, the quality of large-cap stocks may outperform slightly, but defensive stocks will likely fare better.
Against the current backdrop, strategists continue to recommend a barbell approach, balancing quality large-cap growth with defense. On the other hand, they advise against investing in lower-quality cyclical stocks and warn against the temptation to expect a broad market rally.