This year and in 2023, Wall Street analysts have been discussing three main potential macroeconomic scenarios and their potential implications on equities, including a soft landing, no landing, and a hard landing.
Only a few months ago, the prevailing expectation among economists and market analysts was that the US economy would achieve a soft landing, avoiding a significant downturn while cooling inflation.
However, recent macroeconomic data have begun to align more with a scenario where the economy experiences no landing, analysts at Morgan Stanley said in a Sunday note. No landing is a case where the economy continues to grow without entering a downturn.
Recent figures for growth and inflation have surpassed the forecasts of many analysts, including those from the Federal Reserve, indicating a more robust economic performance than previously anticipated.
“Over the past year, consensus views have gone from a hard landing in 1Q23 to a soft landing in 2Q23 to a hard landing in 3Q23 to a soft landing in 4Q23 to no landing currently,” analysts wrote in the note.
This shift has had a noticeable impact on market dynamics, the analysts noted, particularly benefiting reflation trades in recent months.
While cyclically sensitive stocks and sectors have begun to outperform, indicating a preference for riskier assets, the performance leaders still exhibit a strong emphasis on quality, they said.
“We think this combination of quality and cyclical factors makes sense in the context of what is still a later- rather than an early-cycle reacceleration in growth. If it were more the latter, we would expect to see more persistent outperformance of low-quality cyclicals and small caps,” they said.
“Further, we continue to believe that much of the upside in economic growth over the past year has been the result of government spending, funded by growing budget deficits.”
Analysts also outlined that the current fiscal stimulus aims to serve as temporary support until sustainable economic growth is achieved through organic private income and spending. The equity market is expected to favor quality stocks until these conditions stabilize.
Meanwhile, the biggest risk to broader stock performance arises from increasing long-term interest rates, driven by higher inflation and a larger supply of bonds needed to finance deficits. Recent data shows that the correlation between stock prices and 10-year Treasury yields has turned negative, impacting stock valuations, especially affecting small caps and highly leveraged cyclical stocks.
“Given that the rally in equities since October has largely been a function of higher multiples as rates came down, it’s rational to assume that multiples may now face headwinds if rates rise further,” analysts said.