Morgan Stanley
  • Wealth Management
  • Mar 8, 2021

Are We Nearing Peak Growth?

As we approach a year since the initial rebound from the COVID-19 recession, positive rates of change are bound to slow, which means markets may move sideways for a while.

After roaring to new highs at the start of the year, U.S. stocks have pulled back in recent weeks, amid rising interest rates and higher volatility. Positive economic news still points to an improving job market and higher corporate profits. 

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Yet, Wall Street sometimes has a unique way of turning good news into bad. In this case, investors calculated that stocks may have grown overvalued, as rising interest rates narrowed equity risk premiums. The simultaneous decline in stock and bond prices, which move inversely to interest rates, also eroded the value of diversification. Investors also started to consider whether faster-than-expected economic growth might lead the Federal Reserve to moderate its ultra-dovish policy stance sooner than expected.

However, interest rates may be near their peak. With the 10-year Treasury yield at 1.6%, up from 0.5% last August and near Morgan Stanley’s year-end 2021 forecast of 1.7%, we also expect market volatility to recede.

But another market risk looms. Once the year-over-year rates of positive change in key measures of economic and earnings growth and Fed stimulus start to decline, they may fall dramatically, which could negatively affect market sentiment. Consider these three examples: 

  • GDP growth: Forecasts for the first quarter range between 8% and 10%. The second quarter may look even better, as we lap last year’s March-May trough, and the federal government begins to distribute its latest round of fiscal stimulus. In total, nominal 2021 growth could near 10%. Then, the comparisons get tough, with 2022 GDP growth estimates falling to 2.9% and beginning a drum beat of lower quarterly comparisons.
  • Earnings: Decelerating rates of improvement may be a factor in corporate earnings comparisons. Morgan Stanley Chief Investment Officer and Chief U.S. Equity Strategist Mike Wilson forecasts 27% year-over-year growth in S&P 500 profits in 2021, which is seven percentage points above prior historic peaks. Yet in 2022, even as economic growth remains robust, the anticipated rise in capital, labor and materials costs—and potentially higher tax rates, could erode operating profits and lead to lower year-over-year earnings growth.
  • Government Stimulus: In 2022, we expect the Fed to gradually retreat from its peak policy accommodation. That could mean scaling back its bond-buying program. In 2013, a similar tapering move led to a jump in interest rates and a selloff in stocks. In addition, government relief payments to the unemployed, small businesses, states and lower income households, which totaled $6 trillion during the pandemic, will likely end in 2022.

These transitions, which we see arriving as the U.S. economy continues to improve, could cause U.S. equity prices to move sideways, as investors adjust to a slower rate of growth than they had experienced the year before. Keeping a diversified portfolio that avoids big bets on one style, sector or region, may be the best defense when positive rates of change start to slow.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 8, 2021, “Change in Rates or Rates of Change?” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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