Morgan Stanley
  • Thoughts on the Market
  • Jan 11, 2021

So… What Isn’t Priced-In?

With Mike Wilson
U.S. Equities Research for Investors


Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 11th, at 11:30 a.m. in New York. So let's get after it.

Last week, I discussed the growing potential for a sweep by the Democrats in the Georgia run-off elections. Prior to the election, this was a surprise outcome, and therefore not priced. Our take was that it would lead to higher long-term interest rates, and further support our preferred sectors and styles. More specifically, pro-cyclical sectors levered to high economic growth, inflation and interest rates. These include materials, financials, consumer discretionary/services, cyclical technology stocks like semiconductors, and industrials. Fast forward to today, and that's basically what happened. 10-yr Treasury yields moved sharply higher last week as pro-cyclical sectors soared. Meanwhile, stocks most vulnerable to higher interest rates, like high dividend paying defensive sectors and Secular Growth underperformed.

While this new market leadership was already well-established last year, we're now at the beginning of a new calendar year; and this means YTD performance is back to zero and asset managers can no longer ignore it. As I've been discussing for weeks, the turning of the calendar can often lead to more aggressive portfolio shifts as these performance spreads widen. For example, while the S&P 500 had a very good start to 2021, up about 1.9% on the week, it pales in comparison to the Russell 2000 - or small cap index - which is up almost 6%. And many of the cyclical sectors that many asset managers are underweight. For example, energy was up about 9%, banks up almost 8%, and Materials up almost 6%. Even within the growth sectors like technology, there's a widening spread of performance between these cyclical areas like Semiconductors up 4%, and secular growers, like Software and Services, which are actually down for the year. The election last week is just fuel for a more accelerated move of these well-established trends.

In addition to this important political catalyst that supports our call for a regime shift from monetary to fiscal policy dominance, we also have higher revisions in earnings estimates for the smaller and more economically sensitive companies. For example, over the past 2 months, 2021 earnings estimates for the small cap Russell 2000 have increased by 6%, while they're flat for the larger cap S&P 500. At the sector level it's the same story, with 2021 earnings estimates for energy stocks up 13%, while Software, Utilities, Staples and REITs are all flat to down.

Looking forward, 2021 is very likely to be a good year for the economy and earnings growth. In fact, we have more confidence in our V-shape recovery that we've been forecasting, even as a second wave of the pandemic runs its course. As is often the case, though, markets do better when the economy and earnings are weak like last year, because they are discounting machines and looking forward to better times. By the time the data improves, it's already priced. Therefore, 2021 is likely to be better economically, but asset markets are unlikely to repeat their performance of the past 9 months.

Our favored areas for investment remain assets that have the most leverage to accelerating economic growth, higher interest rates and inflation. These also happen to be assets that have underperformed over the past decade, making them cheaper than the broader indices. Along those lines, that includes smaller cap companies, financials, materials, consumer discretionary, and select energy stocks. Commodities also remain favorable in our view. Conversely, assets that are more vulnerable to rising interest rates may underperform and even go down this year. These include high dividend yield stocks and unprofitable growth stocks with big valuations. Finally, the rise in interest rates last week may be the start of a bigger and more sustainable move. If so, all asset prices look vulnerable in the short term to some kind of a correction. We suggest being patient in here with new purchases, as the data catches up with what markets may have already discounted.

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Although 2021 is likely to be a better year economically, asset markets may not repeat the remarkable run of the past 9 months. So where should investors look?

Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.

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