By Vishwanath Tirupattur, Morgan Stanley global head of Quantitative Research
It has been quite a week. Yields on benchmark 10-year US Treasury rates plunged to levels not seen since early February, equity markets sold off aggressively, just a week after the S&P 500 hit a record high, volatility spiked, and it was just Monday! The popular explanation then was that the markets are worried that economic growth will falter because of the sharp increases in new COVID-19 infections caused by the Delta variant. As we get to the end of the week, markets are back to near where they started. So, where do we stand on the key market debates and views?
We disagree with the notion that economic growth is faltering. In fact, our US economists are tracking second quarter GDP at nearly 12%. While they expect the pace of growth to slow, they continue to see a robust economic recovery in place. Their base case projections for both US and global growth for 2021, at 7.1%Y and 6.5%Y, respectively, have not changed.
While the Delta variant is undoubtedly serious, evidence continues to show that vaccines are highly effective in reducing serious illness, hospitalizations and mortality rates. The Delta variant is more transmissible, but as our biotechnology analysts, Matthew Harrison and Mark Purcell, have noted, we do not believe that the dynamics of the virus are different. Vaccination remains the key. In countries with high vaccination rates, there is an increasing disconnect between rising COVID-19 cases and hospitalizations and deaths (with hospitalizations trending to lower ages/less severe disease/shorter stay times), while in countries with low vaccination rates, COVID-19 cases and hospitalizations/deaths are rising proportionately. Risks remain elevated in countries with low vaccine penetration, especially in South and South East Asia, Africa and other EM economies.
Even though economic growth remains on a firm footing, our strategists are concerned about valuations across a wide range of asset classes. As always, markets are forward-looking and reflect not only expectations of a robust global economic recovery but also the uncertainties around the recovery path. As our chief US equity strategist, Mike Wilson reminds us, it is important to keep in mind that while overall growth is still solid, the rate of change has peaked, as reflected in the consistent underperformance of small-cap and lower-quality stocks over the last few months. He favors stocks with earnings stability rather than growth. His recent upgrade of Consumer Staples and downgrade of Materials is reflective of his more defensive stance on US equities.
We continue to believe that the recent plunge in Treasury yields is really about positioning unwind. Furthermore, improving prospects for the passage of an infrastructure package by the US Congress would put upward pressure on yields. Guneet Dhingra, our US interest rate strategist, remains firm in recommending 10-year US Treasury shorts, with the expectation that yields will retrace the declines of the last couple of weeks. We still see 10-year US Treasury yields ending the year at 1.8%.
In currencies, our view is that the US dollar will continue to gain ground in the short term. James Lord, our chief currency strategist, sees (1) the lower likelihood of travel and other restrictions in the US relative to several countries in Europe and Asia and (2) the growing divergence in both inflation trajectory and monetary policy between the US and other large economies as rationale for the long US dollar view.
In corporate credit, valuation concerns are at the forefront of our views. As Vishwas Patkar, our US investment grade strategist, has highlighted, despite a slight widening, investment grade index spreads are still close to their post-GFC tights, arguably the richest they have been in decades. At these levels, credit is priced for perfection, not just for a strong economic backdrop but also a prolonged period of easy liquidity, leaving it vulnerable to a negative surprise. Within credit, even though valuations are also rich in both high yield and leveraged loans, relative valuations point to the investment grade sector being meaningfully richer than its high yield counterpart. Thus, we see the direction of travel for investment grade credit to be towards modestly wider spreads.
In agency MBS, we maintain our long-term structural underweight view. As Jay Bacow, our agency MBS strategist notes, the prospect of the Fed tapering MBS purchases and a pick-up, albeit from low levels, in bank loan growth mean that demand for agency MBS from two large current buyers – the Fed and the banks – could decline simultaneously, supporting his case for the underweight.