'Regime change': As yields rise, the outlook for US stocks may have just fundamentally shifted

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  • Morgan Stanley says rising bond yields spark a shift in US allocations from growth to value stocks.
  • They favour energy, utilities and financials over tech and consumer discretionary stocks.
  • Morgan Stanley also thinks a bear market correction could arrive in 2019, sooner than markets currently expect.

The Morgan Stanley equities team now thinks a “tipping point” has been reached in the investment cycle for US stocks.

And as a result, the relative advantage of growth stocks compared to value stocks — a dynamic which has been in play for the last 10 years — could be coming to an end.

What’s the difference between growth and value?

Growth stocks are defined as companies with the potential for high future capital returns (e.g. Netflix or Tesla). Value stocks are seen to trade at a low price relative to their earnings fundamentals.

Morgan Stanley’s thesis is tied back to last week’s spike in US bond yields, which has given rise to a broad selloff across global stock markets.

And the analysts expect US bond yields to rise further as the Fed sticks to its rate-hiking path.

The resulting moves will bring “end-of-cycle risks into focus”, while also “capping equity market valuations”, it says.

In other words, the US economy is running hot — for now — after years of monetary stimulus and a short-term boost from the Trump administration’s tax cuts.

However, more rate rises and higher yields will ultimately bring the US economy to a halt. But “before this occurs, it appears we will get a final spike higher,” in yields, Morgan Stanley says.

So what does that mean for stocks?

Morgan Stanley said the S&P500’s reaction to the spike in yields was similar to the selloff in early February — except for one key difference.

“Valuations today are much more varied across sectors and styles than they were in January when almost everything was rich.”

But since then, gains have been driven largely by three sectors — tech, health care, and consumer discretionary stocks:

Morgan Stanley

“The good news is that tech has started to correct in the past month, leaving discretionary and health care as the real outliers now,” the equities team says.

And that trend is likely to consolidate as more fund managers re-balance their portfolios away from growth sectors.

“We suspect other asset allocators who have remained overweight US growth equities may now be forced to consider making a switch.”

By sector, the analysts now favour energy, utilities and financials over tech and discretionary stocks.

Utilities — which offer a steady return similar to bonds — may look like an odd choice in an era of rising rates.

But Morgan Stanley says more defensive stocks may prove their worth once the US economy starts to slow — and that could happen faster than markets expect.

It says US growth is likely to be interrupted by a cyclical bear market as soon as next year, one the sugar-hit effects of the Trump tax cuts wear off.

“Our concern lies with the fact that 2019 consensus forecasts do not anticipate such a dynamic at all,” the analysts say.

As a result, the analysts are more sceptical than the broader market and they expect the S&P500 to remain range-bound between 2,400-3,000 for the rest of this year.

Morgan Stanley

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