April hasn’t been very welcoming for US stocks so far as higher rates continue to pressure valuations and heavy fiscal spending complicates efforts to tame inflation. As a result, the S&P 500 fell more than 5% this month, retreating below the 5,000 mark for the first time since February.
According to Morgan Stanley equity strategists, the weak performance in equities in April comes primarily due to the repricing of anticipated Federal Reserve rate cuts and the subsequent increase in back-end rates.
They note that the recent compression in multiples has occurred alongside a significant rise in the 10-year yield, which has moved decisively above the 4.35-4.40% range they have been monitoring since last month.
“As discussed in recent notes, with most of the rally in stocks since October due to higher valuations as a function of lower rates, it seems reasonable that multiples should now fall if yields stay elevated/rise further,” Morgan Stanley strategists wrote.
Looking forward, if yields remain at their current levels over the next three months, equity multiples could experience a modest additional downside of around 5%, assuming all other factors remain constant. That would translate to the S&P 500 dropping to the 4,700 - 4,800 range, they said.
“As discussed last week, should bond yields see additional upside from a rise in the term premium (like last summer/fall), the impact on valuation could be greater given the sensitivity stocks showed to that factor last fall,” the bank’s team noted.
Sector-wise, strategists remain bullish on Energy stocks, along with maintaining a quality bias across both growth and cyclical groups.
What’s causing the headwinds for S&P 500?
In their note, Morgan Stanley highlighted a growing concern among its clients about whether “a policy error may be in the making.”
Firstly, the team observes that last year's aggressive fiscal stimulus significantly boosted economic growth, with nominal gross domestic product (GDP) growth hitting approximately 8% in Q3 and around 6% for the full year.
Secondly, this stimulus contributed to a sizable budget deficit, which in turn led to a challenging funding environment and an increased term premium last summer and fall.
During this period, the Treasury reduced its expected coupon issuance, which spurred considerable demand for duration towards the end of the year, shortly after which the Fed announced a surprisingly dovish shift which further supported this demand.
“By letting the bond market run with a very dovish narrative, we ended up with ~7 rate cuts for this year priced by early January and a 10-year yield of ~3.8%,” strategists highlighted.
“In short, the squeeze from lower coupon issuance and dovish commentary from the Fed resulted in a dramatic fall in rates,” they added.
This decrease in rates sparked a significant rally in risk assets, which in turn created a wealth effect and eased financial conditions considerably.
Strategists said it’s difficult to overlook how this surge in asset prices contributed to stronger growth and higher-than-anticipated inflation, which now hinders the Fed from adhering to its previous dovish stance.
“As a result, the bond market has run with this hotter than anticipated data and is now pricing just 1.5 cuts this year,” Morgan Stanley’s team pointed out.
“In a worst case scenario, some are wondering whether the Fed may even have to hike rates again. Time will tell, but the recent reversal in data has put the Fed back in hawkish mode, and that presents a headwind for valuations,” they said.
As mentioned earlier, should yields remain constant over the next three months, the S&P 500 could see a 5% decline in multiples, potentially adjusting the index's valuation support level, depending on upcoming interest rate decisions.
Furthermore, despite Congress likely approving a $95B foreign aid bill, the ongoing lack of fiscal discipline is countering the Fed's inflation control efforts, leading to an increased hawkish bias, strategists noted.
“With 10-year yields now well above our key 4.35-4.40% level, stock appreciation from here will largely have to be earned through earnings upside rather than multiple expansion,” they said.