Morgan Stanley
  • Wealth Management
  • Mar 8, 2021

Are We Nearing Peak Growth?

As we approach a year since the initial rebound from the COVID-19 recession, positive rates of change are bound to slow, which means markets may move sideways for a while.

Lisa Shalett Chief Investment Officer, Wealth Management 

After roaring to new highs at the start of the year, U.S. stocks have pulled back in recent weeks, amid rising interest rates and higher volatility. Positive economic news still points to an improving job market and higher corporate profits. 

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Yet, Wall Street sometimes has a unique way of turning good news into bad. In this case, investors calculated that stocks may have grown overvalued, as rising interest rates narrowed equity risk premiums. The simultaneous decline in stock and bond prices, which move inversely to interest rates, also eroded the value of diversification. Investors also started to consider whether faster-than-expected economic growth might lead the Federal Reserve to moderate its ultra-dovish policy stance sooner than expected.

However, interest rates may be near their peak. With the 10-year Treasury yield at 1.6%, up from 0.5% last August and near Morgan Stanley’s year-end 2021 forecast of 1.7%, we also expect market volatility to recede.

But another market risk looms. Once the year-over-year rates of positive change in key measures of economic and earnings growth and Fed stimulus start to decline, they may fall dramatically, which could negatively affect market sentiment. Consider these three examples: 

  • GDP growth: Forecasts for the first quarter range between 8% and 10%. The second quarter may look even better, as we lap last year’s March-May trough, and the federal government begins to distribute its latest round of fiscal stimulus. In total, nominal 2021 growth could near 10%. Then, the comparisons get tough, with 2022 GDP growth estimates falling to 2.9% and beginning a drum beat of lower quarterly comparisons.
  • Earnings: Decelerating rates of improvement may be a factor in corporate earnings comparisons. Morgan Stanley Chief Investment Officer and Chief U.S. Equity Strategist Mike Wilson forecasts 27% year-over-year growth in S&P 500 profits in 2021, which is seven percentage points above prior historic peaks. Yet in 2022, even as economic growth remains robust, the anticipated rise in capital, labor and materials costs—and potentially higher tax rates, could erode operating profits and lead to lower year-over-year earnings growth.
  • Government Stimulus: In 2022, we expect the Fed to gradually retreat from its peak policy accommodation. That could mean scaling back its bond-buying program. In 2013, a similar tapering move led to a jump in interest rates and a selloff in stocks. In addition, government relief payments to the unemployed, small businesses, states and lower income households, which totaled $6 trillion during the pandemic, will likely end in 2022.

These transitions, which we see arriving as the U.S. economy continues to improve, could cause U.S. equity prices to move sideways, as investors adjust to a slower rate of growth than they had experienced the year before. Keeping a diversified portfolio that avoids big bets on one style, sector or region, may be the best defense when positive rates of change start to slow.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 8, 2021, “Change in Rates or Rates of Change?” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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