Three risks for an equity market correction and ongoing volatility – Morgan Stanley

Despite sharp pullbacks in some corners of the market, most US stock indexes remain near all-time highs. Here’s why investors shouldn’t be lulled into complacency, according to Lisa Shalett, Chief Investment Officer, Wealth Management at Morgan Stanley.

It’s as important as ever for investors to guard against complacency

Higher inflation and interest rates

“April’s Consumer Price Index (CPI) and Producer Price Index (PPI) readings came in much higher than projections, with several ‘core’ CPI inputs concerningly high. While aspects of recent inflation are likely transitory, a number of secular shifts now underway suggest that higher prices could persist. In addition to boosting corporate borrowing costs, higher interest rates, which often accompany inflation, may hamper equity valuations.”

A decline in positive economic surprises 

“The Citi US Economic Surprise Index, which measures data surprises relative to market expectations, has slid from 92.2 to 14.7, having briefly hit negative territory shortly after last week’s disappointing housing-starts report. Waning upside momentum in economic data may indicate decelerating growth.”

Profit headwinds

“Supply-chain imbalances, rising input costs and higher wages could pressure company earnings in some industries. This could exacerbate less favorable year-over-year comparisons, as we move more than a full year beyond the onset of the pandemic in 2020.”

“These factors, along with the potential for higher taxes and central bank bond-purchase tapering, increase odds of an equity market correction and ongoing volatility. However, bouts of volatility can create opportunities for investors to shift portfolios toward quality stocks, especially those with high and defensible returns on equity and free-cash-flow yields, as well as those with favorable prospects for growth at a reasonable price. We believe investors should also consider avoiding large overweights to major passive market-capitalization-weighted indexes.”