The bond market is signaling a shift that wealth advisors and RIAs should closely monitor. According to Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist at Morgan Stanley, recent moves in bond yields highlight key areas for investment focus.
The yield on the benchmark 10-year U.S. Treasury recently surpassed 4.5%, a crucial psychological threshold for investors that suggests expectations for interest rates remain elevated. Wilson views this level as a pivotal point for equity valuations, signaling that rates are no longer as supportive of high stock market valuations as they have been in recent years.
"In December, we identified 4%-4.5% as the sweet spot for equity multiples, provided growth and earnings stayed on track. Now that yields have exceeded 4.5%, earnings have become the primary driver of returns, and we expect this to persist," Wilson stated on Morgan Stanley's "Thoughts on the Market" podcast.
This shift in market dynamics has led Morgan Stanley to favor large-cap quality stocks, emphasizing sectors with strong earnings revisions. Wilson pointed to financials and media & entertainment as areas of strength, both of which have outperformed in recent months. The Financial Select Sector SPDR Fund and the Communications Services Select Sector SPDR Fund have each gained 7% year-to-date, outpacing the S&P 500's 4% rise over the same period.
Additionally, Wilson noted a preference for software stocks over semiconductor stocks, as well as a tilt toward services over goods due to superior earnings performance. Among defensive sectors, Morgan Stanley favors utilities over real estate investment trusts and healthcare stocks, highlighting their resilience in the current economic environment.
"While our favored trades have performed well, we are maintaining our preference for large-cap quality unless 10-year Treasury yields fall sustainably below 4.5% without a meaningful deterioration in growth," Wilson said.
Yields have been trending higher since the beginning of the year, driven largely by rising inflation and expectations of sustained higher interest rates. The yield on the 10-year Treasury surged in response to economic signals, reflecting market anticipation of inflationary pressures.
Meanwhile, the outlook for Federal Reserve interest rate cuts has diminished. Inflation has been creeping higher, leading investors to largely expect the Fed to maintain its current policy stance for the next several meetings. According to the CME FedWatch tool, market participants anticipate the central bank will hold rates steady. Morgan Stanley projects only one 25 basis-point rate cut this year, likely in June, Wilson added.
For wealth advisors and RIAs, these insights underscore the importance of strategic positioning in portfolios. With earnings now the dominant market driver, a focus on quality stocks with strong earnings growth remains key. Additionally, staying attuned to Treasury yields and Fed policy expectations will be critical in navigating the evolving investment landscape.
