The month of May has been a bit of a bumpy ride for investors, at least compared to the breakneck growth that we experienced earlier this year. The most commonly cited reason for the recent slowdown is the flare-up in the U.S.-China trade conflict. But not everyone agrees. A report from Morgan Stanley’s (MS, Financial) chief investment officer argues that the seeds of this weakness have been sprouting for some time now.
Weak data that goes beyond the trade war
The report begins by pointing out that recent economic data has disappointed, but this fact has been overshadowed by the U.S.-China trade conflict:
“First quarter durable goods orders were much weaker than expected, coming in at -0.9%, with a big downward revision to the prior month as well. Capital spending also disappointed, leading our economists to reduce their second-quarter GDP forecasts to just 0.6% growth - the weakest since the fourth quarter of 2015, and the last time we had an earnings recession. Finally both the manufacturing and services components of the Purchasing Managers Index (PMI) were much weaker than expected.”
Durable goods orders are a commonly used measure of economic activity because they reflect businesses’ expectations for their prospects in the mid-term future. If companies think the economy will do well, they will place bigger orders. If not, they will lighten up. It is closely related to the level of capital spending, which as we see, also underperformed expectations. As these are leading indicators, these results may not yet be reflected in stock prices, and crucially, they are largely unrelated to the trade war:
“Many investors seem to think the recent slowdown has to do with the re-escalation of US-China trade tensions. But all the data points I just mentioned were for the month of April, which reflect economic activity before the trade tensions picked up in May. In other words, things were already slowing before the re-escalation on trade tensions. Such re-escalation will only make it worse.”
The market supports this theory
This may seem far-fetched, given the strong performance of the stock market prior to the latest flare-up in the trade war. The gains have not been equally spread, however:
“The good news is that markets are not completely naive to the idea of slowing growth. All year, defensive and high-quality stocks have been leading the performance of the broader indices, some of which made new all-time highs. It also explains why the S&P 500 is outperforming the riskier international markets again this year. And finally, ten-year Treasuries and other government bonds are making new highs every week, as investors seem to be hunkering down for slower growth, even before the re-escalation of trade tensions began.”
Outperformance in blue-chip stocks and low-risk securities like government bonds is a classic hallmark of a coming slowdown, as the savviest investors shift their capital into safe haven assets. Accordingly, the report recommends investors take a more defensive stance:
“If you listen to what the markets have really been saying this year, they seem to be in agreement with our view for growth to disappoint. Therefore, we continue to recommend that investors remain defensively positioned within their equity portfolios, with overweights in areas like utilities, REITs and consumer staples.
High-quality growth stocks also continue to do well, but you need to be more selective now, because if growth slows further, many of these stocks could disappoint on earnings. We suspect some technology stocks could be particularly vulnerable given the new evidence of a slowdown in capital spending, and their high valuations which do not reflect this risk”.
Disclosure: The author owns no stocks mentioned.
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