Current macroeconomic data indicates signs of economic weakness, leading to underperformance in low-quality and economically sensitive market sectors, while a few high-quality large-cap stocks are driving market performance.
Morgan Stanley strategists suggest that this reflects a market "increasingly focused on slowing growth, with diminished attention to inflation and interest rates."
"The poor performance of small-cap stocks despite declining interest rates is a prime example of this phenomenon," the strategists wrote.
They added, "This backdrop aligns with our long-held view that the current policy mix—significant fiscal spending and higher front-end rates—effectively crowds out many economic participants."
Unless there is a major shift in macroeconomic conditions, Morgan Stanley believes that large, high-quality stocks will continue to lead market performance. The Wall Street giant identifies three potential triggers that could lead to such a change.
First, a resurgence in inflation and growth could prompt the Federal Reserve to reconsider rate hikes. However, Morgan Stanley's strategists note that this scenario is unlikely and undervalued by the market. If it does occur, it could broaden stock market gains to include small-cap stocks and regional banks, though higher interest rates might impact large-cap stock valuations.
Additionally, deteriorating liquidity could lead to outflows from equities, especially as government deficit funding comes into focus.
"A good way to monitor this risk is by watching the term premium, which is currently near zero," the strategists said. "If this changes and the term premium rises as it did last autumn, we expect a broad decline in stocks, with only a few performing well."
They added that the current liquidity supply mitigates this risk.
