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Morgan Stanley: market drop-off was just the appetizer

(FinancialPress) — Morgan Stanley believes that the early 2018 drop-off in the U.S. stock market is only a taste of what could come from rising bond yields. The hardest part, they say, is still to come.

The bank‘s strategists described the crash period in January to early February as an “appetizer, not the main course“. The key metric of inflation-adjusted yields remain within range for the past five years, despite the fact that higher bond yields were difficult to process for equity investors – said a note released on Monday.
While the warnings of that faster inflation could damage stock value, theoretically larger price gains should be, in a worst case scenario, neutral – as long as they boost earnings in the process. However, higher real yields do mean a bigger discount rate has to be applied when valuing future earnings. If they were to break out of the previously mentioned five-year range amidst investors‘ anticipation of greater central bank policy normalization, Morgan Stanley thinks that stocks could take a greater hit. 

Somewhat low real yields were an important support for equity valuations – so a higher break would mean that stocks will have to fall back on earnings instead of on multiple expansion in order to thrive higher – reported Andrew Sheets, head of the London-based financial institution, and his colleagues, in the paper.  The real issue there is that Q2 could see the beginning of a slowdown. “It’s when growth softens while inflation is still rising that returns suffer most,” the strategists wrote.

“Strong global growth and a good first-quarter reporting season provided an important offset. We remain on watch for ‘tricky handoff’ in the second quarter, as core inflation rises and activity indicators moderate.”

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