Morgan Stanley Answers The 10 Biggest Questions In The Stock Market

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Concerns about interest rates, China, housing, and a host of other issues dogged some investors in the first half of 2013.

So in a new 21-page note to clients, Morgan Stanley strategist Adam Parker breaks out the 10 biggest investment questions going forward for the rest of year — and attempts to answer them.

We paraphrase and pull some key quotes here:

1. Will Price-Earnings multiples expand or contract?

“Our best guess is that there will be modest further multiple expansion,” writes Parker. “Given there has not been a large capital spending surge, a large hiring boom, or inventory build-up, outside of say China-infrastructure-exposed names, it’s hard to see why we would have a huge reduction in corporate earnings. Therefore, if the probability of a bear case isn’t that high, and the severity of a bear case isn’t that acute should one surface, modest multiple expansion is likely.”

2. Will interest rates keep rising, and what are the implications? 

Morgan Stanley believes bond yields will hover around today’s level for the next few months. “We are not so concerned about rates backing up to the point of slowing the housing or even the economic recovery,” Parker says. “Moreover, we think the Fed will remain accommodative for another year. There is just no reason to not believe Bernanke.”

3. Will the US corporate sector contribute to growth? 

In short, not really. From Parker: “There will not be a large capital spending surge – because one isn’t necessary or required and because demand doesn’t appear good enough to cause management teams to build more capacity in advance of it being evident.”

4. Do we want to own Cyclical stocks or Defensive stocks?

A little bit of both, argues Parker. When yields were really backing up, however, the anti-defensive sentiment grew too quickly. “We do maintain positive biases on autos and media,” Parker writes. “On the other hand, we would continue to avoid energy and materials exposure, or any stocks – like select machinery – with high exposure to a strong acceleration in China infrastructure.”

5. What are the remaining opportunities related to housing?

Be careful when timing housing-related stocks as the “normalization” of the housing market rolls on. “When new starts recovered from 450,000 to 900,000 the stocks were great,” Parker writes. “As starts recover and normalize to the long-term trend of 1.2 to 1.3 million, and the second derivative of nearly every fundamental metric is negative, the stocks may perform more poorly.”

6. WTI and Brent crude prices have converged: What are the key energy issues?

“It does seem that energy could continue to languish on a relative basis,” Parker says, but Morgan Stanley gives the sector a market-perform rating thanks to the “attractive relative valuation as representative of lower oil prices in the future.”

7. Do we want US stocks with China exposure?

Everyone has been wary of high exposure to emerging markets, but Morgan Stanley is relatively bullish on China. “Ultimately, whether China’s economy grows 4, 5, 6, or 7%, aren’t all of those levels likely better than the US, Europe, and Japan?” asks Parker. Morgan Stanley thinks the anti-China pendulum has swung too far, and by the end of the year, investors will be looking to go long instead of short on US stocks with high China exposure.  

8. Should US investors care about Europe?

Every European mini scare over the last 2 years has been like the Y2K “crisis,” Parker says. Not that Europe is somehow “solved,” but pops in Europe won’t spark as much fear in US stocks going forward. Will Europe matter in the second half of 2013? “Probably not,” concludes Parker.

9. Low Cost of Capital: What are the implications for capital spending, M&A, etc?

The two prominent uses of cash this year will be for dividend growth and (eventually) M&A, according to Morgan Stanley.

As companies’ balance sheets improve, few are likely to go bankrupt, argues Parker. But this also means that a “relief rally” where stressed companies get capital and outperform is also unlikely. “At some point, this could be a huge problem for companies if bond yields materially back up in 2016 or 2017 when they look to refinance, but few US equity investors will be that anticipatory,” Parker writes.

10. What are our sector bets?Overweights: Health Care, Industrials, Technology

Market-Weights: Financials, Materials, Telecoms, Utilities, Energy

Underweights: Staples, Discretionary

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