Morgan Stanley: Investors are underestimating two risks

In December, the Federal Reserve interest rate decision boots landed, investors began to focus on the Omicron mutation virus.

But Michael Wilson, Morgan Stanley's chief US equity strategist, believes the market is unprepared for a change in Fed policy.

The Fed may be beginning the long process of exiting its easy money policies, on which markets have long grown accustomed to relying.

While most major U.S. stock indexes remain near or at record highs, the sector rotation shows that the market has been considering such a shift by the Fed for months.

Shortly after the Jackson Hole meeting in late August, Chairman Powell first suggested tapering asset purchases before the end of the year, and he formally confirmed this message at the Fed's September meeting.

As Wilson notes, this fact has not been forgotten by the market over the past month, as investors have rotated out of the most speculative assets at a historic pace.

The question now, strategists at Morgan Stanley say, is "whether the Fed's policy shift is fully priced in, what areas remain vulnerable and where can investors find positive returns?"

Mr. Wilson has been watching valuations this year, and the most expensive stocks have faltered since the first quarter.

The strategist said the revaluation of U.S. stocks is now based on the equity risk premium (ERP) channel, not interest rates, because using current nominal or real interest rates to translate future cash flows could be a big mistake given the pace of inflation and the Fed's changing response function.

On the upside side, Mr. Wilson has been supporting value stocks since mid-March. In Morgan Stanley's annual outlook, analysts advised investors to focus more on large-cap defensive sectors rather than growth sectors.

The recommendation is based on the view that "the Fed and other central banks will begin to accelerate the exit of accommodative policies, which is bound to impact markets if not the economy."

Needless to say, growth stocks will be more vulnerable to this retrenchment than defensive stocks, given their much higher valuations.

Morgan Stanley strategists favor defensive sectors, arguing that policy tightening and the coming slowdown in economic growth could be worse than most expect.

The bank's two overweight sectors -- healthcare and real estate investment trusts -- have been doing well, and Morgan Stanley continues to be bullish on these two areas.

Morgan Stanley strategists also worry that the economy will slow more than most expect. While Omicron is part of the market's concern in the short term, Mr Wilson is more focused on the risk of a pick-up in supply, which could be compounded by waning consumption.

Consumer confidence remains at recessionary levels, largely due to higher inflation, which is expected to start showing up in spending in the first quarter of next year.

Mr Wilson concludes: