Why an ‘Everything Rally’ Is Still Possible
Digest
Serena Tang, Morgan Stanley's chief cross-asset strategist, discusses the potential for both bonds and equities to rally this year, despite the common belief that rate cuts and falling yields are detrimental to equity performance. She highlights that in the past, when the Fed cut rates, bond yields were lower and equities were up 43% of the time, with stock returns averaging 18% and yields falling over 1 percentage point. Tang attributes this to a benign economic backdrop and the Fed's expected rate cuts. She contrasts this with 2022, where high correlations between stock and bond returns were driven by inflation and sluggish growth, leading to sell-offs in both assets. Today, with robust growth and disinflation, the opposite is likely to occur, with bonds rallying on lower rates expectations and equities benefiting from strong earnings revisions. Tang emphasizes that while correlations remain elevated, they should work in investors' favor this year, making it a strong environment for risk assets. She encourages investors to lean into this opportunity, particularly in European and Japanese equities, as well as fixed-income products like leveraged loans and collateralized loan obligations.
Outlines
Introduction
This Chapter introduces the podcast, Thoughts on the Market, and the speaker, Serena Tang, Morgan Stanley's chief cross-asset strategist. Tang outlines the topic of the episode: why bonds and equities can both rally this year, despite the common belief that rate cuts and falling yields are detrimental to equity performance.
Bullish Outlook on Equities and Fixed Income
This Chapter discusses Morgan Stanley's bullish view on both global equities and parts of the fixed-income space, like agency mortgage-backed securities and leveraged loans. The bullish outlook is based on the benign economic backdrop and the economists' forecast for the second half of 2024.
Challenging Conventional Wisdom
This Chapter challenges the conventional wisdom that equities cannot perform well in an environment of rate cuts and falling yields. Tang argues that this is not always the case, citing historical data that shows equities were up 43% of the time when the Fed cut rates, with stock returns averaging 18% and yields falling over 1 percentage point.
The Flip Side of 2022
This Chapter contrasts the current market environment with 2022, where high correlations between stock and bond returns were driven by inflation and sluggish growth, leading to sell-offs in both assets. Tang argues that today, with robust growth and disinflation, the opposite is likely to occur, with bonds rallying on lower rates expectations and equities benefiting from strong earnings revisions.
Keywords
Morgan Stanley
Morgan Stanley is a global investment bank and financial services company headquartered in New York City. It provides a wide range of financial services, including investment banking, securities brokerage, asset management, and wealth management. The company is known for its expertise in mergers and acquisitions, equity research, and fixed-income trading.
Serena Tang
Serena Tang is Morgan Stanley's chief cross-asset strategist. She is responsible for providing investment insights and recommendations across different asset classes, including equities, fixed income, and commodities. Tang is a recognized expert in the field of macroeconomics and asset allocation.
Cross-Asset Strategy
Cross-asset strategy is an investment approach that considers the relationships and interactions between different asset classes, such as stocks, bonds, and commodities. It aims to optimize portfolio returns by allocating assets across different classes based on their expected performance and risk profiles.
Equities
Equities, also known as stocks, represent ownership in a company. When you buy an equity, you become a shareholder in the company and have a claim on its assets and profits. Equities are considered a higher-risk investment than bonds, but they also have the potential for higher returns.
Fixed Income
Fixed income refers to debt securities that pay a fixed or variable interest rate to investors. Bonds are the most common type of fixed-income security. They are considered a lower-risk investment than equities, but they also have the potential for lower returns.
Correlation
Correlation is a statistical measure that describes the relationship between two variables. In finance, correlation is used to assess the relationship between the returns of different assets. A positive correlation means that the returns of two assets tend to move in the same direction, while a negative correlation means that they tend to move in opposite directions.
Rate Cuts
Rate cuts refer to reductions in interest rates by central banks, such as the Federal Reserve. Rate cuts are typically implemented to stimulate economic growth by making it cheaper for businesses and consumers to borrow money.
Disinflation
Disinflation is a slowdown in the rate of inflation. It occurs when prices are still rising, but at a slower pace than before. Disinflation is often seen as a positive sign for the economy, as it indicates that price pressures are easing.
Leveraged Loans
Leveraged loans are loans that are made to companies with high levels of debt. They are typically used to finance acquisitions, mergers, or other corporate transactions. Leveraged loans are considered a higher-risk investment than traditional bank loans, but they also have the potential for higher returns.
Collateralized Loan Obligations (CLOs)
Collateralized loan obligations (CLOs) are structured finance products that are backed by a pool of leveraged loans. They are typically divided into different tranches, with each tranche having a different level of risk and return. CLOs are considered a complex investment product, but they can offer investors diversification and potential for higher returns.
Q&A
Why do some believe that rate cuts and falling yields are detrimental to equity performance?
The conventional wisdom is that rate cuts and falling yields signal a slowing economy, which can negatively impact corporate earnings and equity valuations.
What historical data does Serena Tang use to challenge this conventional wisdom?
Tang cites data showing that in the past, when the Fed cut rates, bond yields were lower and equities were up 43% of the time, with stock returns averaging 18% and yields falling over 1 percentage point.
What is the key difference between the current market environment and 2022?
In 2022, high correlations between stock and bond returns were driven by inflation and sluggish growth, leading to sell-offs in both assets. Today, with robust growth and disinflation, the opposite is likely to occur, with bonds rallying on lower rates expectations and equities benefiting from strong earnings revisions.
Why are elevated correlations between stock and bond returns considered favorable for investors this year?
Because the correlations are likely to work in investors' favor, with bonds rallying on lower rates expectations and equities benefiting from strong earnings revisions.
What specific asset classes does Serena Tang recommend investors consider?
Tang recommends European and Japanese equities, as well as fixed-income products like leveraged loans and collateralized loan obligations.
Show Notes
Our Chief Cross-Asset Strategist explains why the high correlation between stocks and bonds could work in investors’ favor throughout the second half of this year.
----- Transcript -----
Welcome to Thoughts on the Market. I’m Serena Tang, Morgan Stanley’s Chief Cross-Asset Strategist. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss why we believe bonds and equities can both rally this year, with the still-elevated correlations between the two assets a boon rather than a bane to investors.
It’s Monday, June 3rd at 10am in New York.
In our mid-year outlook two weeks ago, we expressed our bullish view on both global equities and parts of fixed income space like agency mortgage-backed securities and leveraged loans, on the back of the benign economic backdrop our economists are forecasting for in the second half of 2024.
Now, this may be surprising to some. Received wisdom is that in an environment of rate cuts and falling yields, equities can't perform well because the former usually maps to growth slowdowns. When equities see double-digit upside – which is what we’re projecting for European equities – it’s unusual for bonds to also see strong and positive returns, which is what we’re projecting for German government bonds.
And I want to push back on this received wisdom that we can’t have an ‘everything rally’. When we look at the annual performance of global stocks and 10-year US Treasuries every year going back to 1988, in the 13 times when the Fed cut rates over the course of the year, bond yields were lower and equities were up 43 per cent of the time. And in those periods, stock returns averaged 18 per cent while yields fell over 1 percentage points. ‘Everything rallies’ happen often in this very macro backdrop of benign growth and Fed cuts we’re expecting, And when they do happen, everything indeed rallies – strongly.
Or to frame it another way – our expectations for both global equities and fixed income to see strong total returns this year is the flipside of what markets had experienced in 2022. Now back then, unlike in most other prior cycles, stock-bond return correlations were high because inflation was elevated even as growth was sluggish, meaning that bonds sold off on higher rates expectations, and equities on bad earnings. Today, with our view that global growth can be robust while disinflation continues, the opposite will likely be true; bonds should rally on lower rates expectations, and equities on strong earnings revisions. Stock-bond return correlations are still elevated, but it should work in an investor’s favor this year.
Lean into it. Good macro, fair fundamentals, pockets of attractive valuations all make for a strong environment for risk assets, a reason for us to get more bullish on European and Japanese equities, but also in fixed income products like leveraged loans and Collateralized Loan Obligations.
Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.
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