- According to Morgan Stanley Wealth Management, stock-market investors are too complacent about the bond market’s warnings concerning the next recession.
- They observed four trends beneath the surface that should be more attention-grabbing.
- The 3-month/10-year yield curve is mired in its longest inversion since 2007.
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It has reared its ugly head twice this year, first in March and then last month when the difference between 3-month and 10-year Treasury yields turned negative. Amid uncertainty surrounding the trade war, investors piled into long-term bonds and pushed their yields lower.
This inversion, now just under two weeks old, marks the longest stretch since 2007. Inversions that lasted for more than one month served as accurate precursors of all seven recessions that occurred during the last 50 years, according to Morgan Stanley Wealth Management.
For those dismissing this time as different, the firm has identified a number of stock-market trends that strongly suggest otherwise.
"Unlike in March, we now see odds of a protracted inversion as high and have become increasingly cautious, especially since the equity market continues to shrug off weak economic data and the inversion as transitory," said Lisa Shalett, the chief investment officer of Morgan Stanley Wealth Management, in a recent note to clients.
She added: "We have noticed the marked rotation below the headline stock market indexes. We see this market action itself as supportive of the yield curve inversion signal."
The four signals she identified are as follows:
- Small-cap stocks have meaningfully underperformed large-cap stocks and are still 15% below their September 2018 high. Smaller companies are more exposed to the domestic economy and so they’re considered a stronger bellwether of the economic cycle.
- Semiconductor stocks, another very cyclical cohort, are under strain.
- Tech stocks are losing their market leadership to utilities, a sector well known for its defensive properties.
- Beyond the US, South Korean stocks — seen as an indicator for global trade because of the country’s exposure to China — are in a downturn.
With these trends all pointing to trouble ahead, Shalett’s conclusion was that equity investors were relatively complacent, even after the market’s decline in May. In her view, they’re counting too heavily on the Federal Reserve to swoop in and cut interest rates if the trade war continues to worsen the outlook for the US economy.
On the other hand, bond-market investors are pricing in a recession more aggressively, starting with the longest yield-curve inversion since 2007.
Shalett had a recommendation for equity investors who want to prepare for a downturn like their counterparts in the bond market are already doing.
"Consider building a buy list of US financials as they are close to pricing a recession and should benefit if the curve steepens in the next 12 to 18 months," she said.
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