2021 Midyear Investor Outlook: A Tricky Transition

In a little more than a year, the global economy has rebounded from one of the worst recessions on record to growth that likely will surpass its pre-pandemic trajectory. The recovery has also benefited from unprecedented conditions, including the largest fiscal stimulus and monetary easing, as well as the highest consumer savings rates in history—and now, the potential for a significant business investment cycle.

If the macroeconomic outlook seems clear, mapping an investment approach for what Morgan Stanley strategists call a “hotter and shorter" midcycle transition may be anything but straightforward. Investors may need to reconcile early-cycle timing, midcycle conditions and pricey late-cycle valuations—especially for U.S. equities—while also factoring in potential inflation, policy changes and higher corporate taxes.

“Although challenging, these problems are not insurmountable," says Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.

However, they do call for charting a different course. Here are five ideas for navigating the midcycle transition.

Morgan Stanley strategists' have reduced expsosure in their net equity and credit allocations

Following the initial excitement of recovery, the transition to midcycle typically means that higher rates and less dramatic improvements engage in a tug-of-war with earnings and valuations. The current market checks the boxes on the midcycle transition for every key indicator, save one—historically lower valuations. “Midcycle transitions commonly see valuation contractions of 10% to 20%," says Chief U.S. Equity Strategist Mike Wilson.

As a result, Morgan Stanley strategists, who now believe that a broader correction may be overdue, have a neutral weighting on U.S. equities. The team’s contrarian view is based in part on the Federal Reserve’s commitment to “lower for longer” interest rates, giving U.S. equities more room to run. “We do not doubt the Fed's resolve in that regard, but we think it means more tightening later," says Wilson, adding that investors are likely to price this in earlier, rather than later in the cycle.

Despite a more cautious stance on U.S. equities overall, Morgan Stanley strategists believe that sectors that stand to benefit from reflation offer more upside than those tied to reopening. For example, price-to-earnings multiples for consumer discretionary stocks recently traded significantly higher than their historical ratio. Bank stocks, in contrast, sit relatively near their historically low valuation levels and stand to benefit from improving macro conditions and potentially higher rates.

Likewise, valuations for health care stocks appear to be low relative to their historical levels thanks to lingering uncertainty around government policymaking. However, potential risks for policy are now largely known to the market and earnings may be set to improve. “We think a catch-up trade is very feasible," Wilson says.

Morgan Stanley strategists maintain their small overweight on global equities—thanks to favourable views on Europe and, to a lesser extent, Japan. “Both regions have less inflationary pressure, less risk of changing tax or central bank policy and less expensive valuations," says Sheets.

European equities stand to benefit from global reflation, given the region’s relatively early stage recovery. Europe is also one of the few regions forecasted to post stronger GDP growth in 2022 than in 2021.

Plus, the price is right: Stocks are relatively inexpensive and anemic inflows year-to-date mean investor attention is still focused on other global equities markets.

European equities should outperform as relative earnings-per-share trends recover from last year's sharp drop

Focusing on investment themes can be a winning strategy in any environment, but alpha-generating investment ideas are even more crucial today, given the limited upside for major equity benchmarks. Many of these themes are global, span sectors and investment styles and are supported by long-term secular shifts. Some examples include:

• Multipolar World: The dissociation between the U.S. and China in key economic areas could impact global business strategy and the investment landscape.
• Data Era: A new computing cycle emerges every decade, increasing access to computing by tenfold. COVID-19 has accelerated the current cycle, which presents opportunities, not just for the tech sector, but also for advanced adopters, such as the manufacturing or health care sectors.
• Red-Hot Capital Expenditure Boom: An expected surge in corporate spending to ramp growth is a pillar of Morgan Stanley's economic outlook, with implications beyond the usual suspects. This theme sits at the nexus of other big ideas, including data, decarbonisation and deglobalisation.

The same dynamics driving up equity valuations have also pushed up prices in global credit. The asset class has had an outstanding run but is both expensive and disadvantaged in a hotter cycle, Sheets says.

Even so, there are nuances worth watching. U.S. credit, for instance, may offer more opportunity down the quality spectrum—but not too far. Morgan Stanley recommends trimming exposure at the very low end of the high-yield bond market.

Valuations also appear stretched among securitised products, but fixed-income strategists continue to be overweight this sector, with a focus on U.S. and European collateralised-loan obligations and commercial mortgage-backed securities.

One notable exception: Agency Mortgage-Backed Securities (Agency MBS) are a different story. With the yield improvement over U.S. Treasuries at all-time lows, strategists have a longer-term structural underweight to this sector.

For more on Morgan Stanley Research on global strategy, speak to your Morgan Stanley financial adviser or representative for the full report “Now the Hard Part" (16 May, 2021). Plus, more Ideas from Morgan Stanley's thought leaders.