The U.S. stock market’s vigorous rally from December’s lows has been powered by the same technology and social-media company shares that have been the centerpiece of the more than decade-long bull market.
However, Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote in a research note dated Sunday, that the 2018 equity rally, subsequent correction and early-2019 recovery have masked the fact that since June, the defensive utilities, real estate and consumer-staples sectors have led the S&P 500 index SPX, -0.51% on a total return basis. Those sectors tend to draw investor interest during heightened concerns about the economic outlook.
Wilson said the gains in so-called defensive stock sectors may partly explain the stellar year-to-date performance of U.S. stocks, with the S&P 500, Dow Jones Industrial Average DJIA, -0.21% and Nasdaq Composite Index COMP, -1.23% all up double digits, against the bond market, where falling yields, which move in the opposite direction of prices, signal investor unease about growth.
Yields for the 10-Treasuy note yield TMUBMUSD10Y, +1.04% were at 2.41% on Monday, down from a peak on April 22 at 2.589%, according to FactSet data. Those moves reflect increased U.S.-China tensions and nagging worries about global economic growth, driving yields lower.
Wilson said focusing on the rally in defensive stocks against other sectors helps to better reflect the cautious equity advance that appears to be under way.
“An alternative observation about the different messages between equity and bond markets is that equity markets may not be sending such a strong signal about growth as one might interpret from just looking at the price level of the S&P 500,” Wilson wrote, adding that “equity markets continue to trade very defensively under the surface.”
“Specifically, low quality stocks have rallied very little from their December lows, while defensive sectors and high-quality stocks are well above their all-time highs reached last year,” Wilson continued: “Meanwhile, small caps have performed terribly along with cyclicals…what we have is a very bifurcated equity market that is paying up for high-quality and defensive stocks while discarding anything with low-quality cyclical assets. Such a condition can definitely persist if growth stays low, but we don’t slip into an economic recession.”
The Morgan Stanley strategist has been skeptical of the stock market’s 2019 recovery — suggesting that investors abandon equities as early as January. He has been calling for an earnings recession, or two consecutive quarters of negative earnings growth, since September of last year. But first-quarter earnings have generally come in better than expected, and will likely show roughly flat growth when the final numbers are tallied, meaning that even if the second quarter features year-over-year declines in earnings, two-consecutive quarters of earnings declines aren’t widely expected.
But while Wilson underestimated the resilience of the S&P 500 in the first quarter of this year he writes that “our models continue to suggest that negative earnings growth is still likely over the next 12 months” and that he sees three major excesses that “need to be purged from the economy” before stocks can begin a sustained recovery.
Those include rising business inventories, the build up of which likely overstated the strength of the U.S. economy in the most recent report gross domestic product, and could be an expensive burden for U.S. companies, especially if growth slows.
Second, he points to the 30% cut in capital expenditures from the big cloud-computing leaders Amazon.com Inc. AMZN, -0.33% Google-parent Alphabet Inc. GOOG, -2.01% Facebook Inc. FB, -1.34% and Microsoft Corp. MSFT, -1.23% as an indication that these firms see slowing demand for products and services.
Finally, he identifies growing costs of labor and inputs, as a result of a tight labor market and higher tariffs, as forces that could lead to cost-cutting, and worker layoffs, which could spark a recession.
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