Morgan Stanley
Wealth Management

Sticking the Soft Landing

Jul 31, 2024

A successful transition to steady economic growth, without a resurgence of inflation, could drive broad stock gains. But risks around AI, growth and monetary policy still threaten that scenario.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Investors are beginning to question the return on tech companies’ AI investments, with uncertainty hitting semiconductor stocks hard.
  • As hopes for momentum from China fade, global growth may not offset a U.S. slowdown, and that could weigh on corporate profits.
  • The Fed’s expected rate cuts may not be enough to stimulate the more rate-sensitive parts of the U.S. economy and markets.
  • Given such risks, investors should consider exposure to large-cap quality cyclical stocks, as well as Japan, gold, hedge funds and investment-grade credit.

It’s been just over a year since the U.S. Federal Reserve last raised interest rates. For most of that time, the question of when the U.S. central bank would begin cutting rates has weighed on many investors, who are hoping that cuts would signal a positive outlook that might support stock valuations.

 

Earlier this month, indications that inflation is cooling assured investors that rate cuts are around the corner. This sparked a massive shift of money from the so-called Magnificent 7 tech stocks to other areas of the market poised to benefit from lower rates and slower, but solid, growth.

 

If an economic “soft landing” comes to pass, as Morgan Stanley’s Global Investment Committee expects, it could continue to drive broader equity gains. But it’s still possible, though less likely, that the economy could either falter or rebound alongside inflation. That means investors still need to position their portfolios for a range of scenarios – and also to consider risks related to three questions that may have an outsized impact on markets.

Q
When will generative AI live up to the hype?
A

That remains unclear. The Magnificent 7 stocks’ valuations remain historically stretched, while the hype around generative AI and optimistic earnings expectations are reminiscent of past tech bubbles. These companies have been fiercely competing in their AI spending—but until recently, questions about the return on these investments and how long they’ll take to become profitable have been purely hypothetical. Investors are now asking such questions more seriously, yet answers so far have been vague, at best. This uncertainty has hit semiconductor stocks hard, but even with their recent pullback, the category’s trailing price-to-earnings (P/E) ratio is about 43 versus the historical 25.

Q
Will global growth offset U.S. economic slowing?
A

That isn’t certain. Granted, rate cuts by other central banks ahead of the Fed might lift select economies in Europe and emerging markets. However, investors’ hopes that China would drive much of the momentum are fading following the recent meeting of China’s leaders, where policymakers seemed flummoxed over how to stimulate consumption. Global bond yields have fallen while industrial metal prices are down, throwing cold water on the idea that global growth will offset a U.S. slowdown and help sustain corporate earnings from here through 2025.

Q
How fast and deep will Fed rate cuts be?
A

We expect rate cuts to be slow and shallow, befitting an economy that is cooling but not falling into a recession. However, we are skeptical that such cuts will be enough to stimulate the more rate-sensitive parts of the economy, such as low-income consumers, commercial real estate, regional banks and housing. Also, if the Fed cuts rates to 3%-3.5%, as we expect, history suggests it would only support stock multiples of about 16-18, which would likely disappoint bullish investors, given that the S&P 500’s trailing P/E ratio has risen as high as 27.5 since the Fed last raised rates. (For those who follow currency dynamics, U.S. rate cuts, alongside potential rate hikes in Japan, would also likely squeeze a popular “carry trade” in which speculators borrow in a weaker yen and invest the proceeds in U.S. assets.)

Investing Implications

Given our expectations that the Fed will cut rates to no lower than 3% and nominal growth will remain under 4%, we see an environment that is likely to reward companies with excellent management, realistic earnings forecasts and undemanding valuation multiples.

 

Investors should consider following the recent shift into large-capitalization quality cyclical stocks. We favor financials, energy, industrials, aerospace and defense, and select power generation and grid infrastructure names, as well as residential real estate investment trusts (REITs).

 

The market’s recent rotation has also benefited small-cap stocks, but we are not convinced those gains are sustainable.

 

We continue to recommend increased exposure to Japan, gold, hedge funds and investment-grade credit in a holistic portfolio.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 29, 2024, “Revisiting Risk Premiums.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

For index, indicator and survey definitions referenced in this report please visit the following:

https://www.morganstanley.com/wealth-investmentsolutions/wmir-definitions

Risk Considerations

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.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

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

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, 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 and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

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

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long-term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be appropriate for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Hedge funds may involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager.

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. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices. Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers. Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.

Artificial intelligence (AI) is subject to limitations, and you should be aware that any output from an IA-supported tool or service made available by the Firm for your use is subject to such limitations, including but not limited to inaccuracy, incompleteness, or embedded bias.  You should always verify the results of any AI-generated output.

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.

The indices are unmanaged. An investor cannot invest directly in an index.  They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices are not subject to expenses or fees and are often comprised of securities and other investment instruments the liquidity of which is not restricted. A particular investment product may consist of securities significantly different than those in any index referred to herein. Comparing an investment to a particular index may be of limited use.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

Disclosures

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice.  Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.

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