Morgan Stanley
  • Wealth Management
  • Jul 9, 2019

U.S. Markets May Be More Fragile Than They Seem

The S&P 500 recently reached an all-time high, but investors may be overlooking some economic warning signs.

Lisa Shalett Chief Investment Officer, Wealth Management

No sooner did the S&P 500 reach a new all-time high than a surprisingly positive economic report—June non-farm payrolls, released last Friday—started a downtrend. The government reported that 224,000 jobs were added last month, vs. economists’ consensus estimate for a gain of 160,000. June’s number represented a sharp rebound from May’s 75,000 reported new jobs, which had set off fresh concerns over the health of the U.S. economy.

While we’ve only seen a brief dip in stocks so far, the decline in the face of positive economic news shows how fragile markets have become. Stocks dipped largely because the positive report makes it less likely that the Federal Reserve will cut interest rates as much as expected at its meeting later this month.

Meantime, most economic readings continue to weaken and many recession indicators are flashing yellow. For example, The New York Federal Reserve’s model forecasting probability of recession in the next 12 months hit 33% for June. That’s up from 28% in May and the highest level since 2009. It has accurately predicted a recession every time it has exceeded 30%.

Most investors haven’t adjusted their expectations to this new reality. In my view, many investors have become too reliant on expectations that global central bankers, including those from Europe and Asia, will stimulate their respective economies to forestall further weakness. I think it’s best for investors to remain cautious. Here’s why:

  • Corporate earnings may disappoint: Current consensus expectations project a 2.4% year-over-year contraction in second-quarter earnings, according to FactSet. Judging from the recent weakness in new orders reported in the U.S. Manufacturing Purchasing Managers Index, it may get worse. This measure is a leading indicator for S&P 500 profits. Many investors are expecting a second half 2019 rebound in earnings, but I believe it may not materialize.
  • Some asset classes are signaling recession: Interest rates, currencies and commodities are all telegraphing a pending recession. Gold prices, for example, which typically rally when investors are worried about the future, have hit a six-year high.
  • Trade protectionism isn’t having the desired effect: The recent “truce” with China doesn’t change the basic economic facts: Tariffs are proving a drag on global growth and the trade deficit is widening. Last week’s report showing imports are growing faster than exports suggests that trade policies will likely continue to drag on GDP growth this year.
  • The yield curve remains inverted: This means that short-term bond yields are higher than long-term yields, a rare occurrence that most economists consider to be one of the most reliable indicators of a pending recession. Currently, three-month Treasury bills are yielding more than 10-year notes for the sixth consecutive week. The longer this inversion lasts, the more reliable it is as a recession indicator.

While markets may rebound from the current dip, I don’t think all these recessionary signals and high stock and bond prices can coexist long term. Given my cautious outlook, I suggest investors take profits in holdings that have outperformed, and seek investment options that offer valuation and yield support. For price appreciation, commodities may be worth exploring.

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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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