US Equity Strategy: Don't Be Late

Being early with one's investments is often just being wrong. However, when momentum is going through a major change, like this year, early is on time. The next big curve ball, higher back end rates, is likely coming. Are you ready?

In life, there are many surprises and things that can't be controlled. Instead, we must adjust our plans to make the most of the situation. 2020 was one of those years where surprises abounded and adjustments were necessary.

In contrast to the experience of 2020, there are some things we can control in our lives that make the journey smoother and easier. If there was one rule in particular that Morgan Stanley’s analysts would recommend, it would be: "15 minutes early is on time and on time is late." While this sounds relatively easy in theory, many find it difficult in practice.

Morgan Stanley Research thinks this "on time" analogy may also apply to investing.

Morgan Stanley Research has been recommending cyclicals and small caps since early April and until recently, these categories were out of favour with most investors, even though both outperformed between April and October. What they heard from many clients was that there was no rush because the old winners were keeping up and until the economy reopened there was no need to make a shift. In other words, why be early? But, all of that quickly changed in November. The combination of the US election and the announcements of not one, but two, highly effective vaccines quickly proved the old "on time" adage right, once again. Since early November, small caps and cyclicals have significantly outperformed. In fact, as Morgan Stanley Research showed in December, these returns are now very much in-line with an economic recovery from a recession. Importantly, one needed to be there early to capture it.

With cyclicals and small caps having outperformed since November and now a consensus preference, Morgan Stanley Research thinks they might take a bit of a break before extending their newfound leadership. After such a meaningful move, a consolidation of these new powerful trends should be expected. Therefore, one should be on the lookout for the next surprise when thinking about how to be positioned.

With Morgan Stanley’s V-shaped recovery story now consensus and most asset prices reflecting that view, the biggest laggard remains the long duration rates market. Furthermore there's not a US market investor Morgan Stanley has spoken to who thinks 10 year Treasuries are a good deal. Of course, offsetting that opinion is the Federal Reserve and other central banks who remain committed to financial repression. In the Fed's case, they appear committed to such a strategy until they see confirmation of full employment and sustainable 2% inflation, something that could take years. As a result, Morgan Stanley hears from clients, "Yes, I see how rates might move higher but why be early?" or "The Fed won't let that happen."

Many cyclicals are positively correlated to long term interest rates. Conversely, defensive stocks are negatively correlated. As Morgan Stanley Research has shown many times, the equity market has moved ahead of the rates market with their cyclical/defensive ratio jumping higher even as 10 year nominal yields remain repressed. The equity market is not waiting for the confirmation from rates making today's divergence extreme. Meanwhile, small caps (Russell 2000) relative to the Nasdaq 100 tend to be more correlated to real 10 year yields. While this divergence isn't as extreme as cyclicals/defensives versus 10 year nominal rates, it has just started to widen over the past month.

Morgan Stanley Research continues to expect the momentum factor to shift more cyclically over the first quarter of 2021. Their Quantitative Strategy looked at what has historically happened when stocks enter the top/bottom quintiles of momentum. They show that New Longs cumulatively outperformed both the market and Existing Longs over the last 10 years while New Shorts meaningfully underperformed the market, but modestly outperformed existing short momentum stocks. In other words, momentum begets momentum.

Morgan Stanley Research believes this shifting momentum and the need to be positioned for it early will be a crucial driver of investment returns in 2021.

For more detail on Morgan Stanley’s US equity strategy, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.