Morgan Stanley says correlation between real rates and equity returns fallen deeper into negative territory

Two prominent US equity strategists on Wall Street hold conflicting views on whether the current stock market rally can continue in light of the persistent elevation of interest rates. Michael Wilson from Morgan Stanley, known for his bearish stance on equities, asserts that the correlation between real rates and equity returns has intensified in the negative direction. According to Wilson, the recent decline in US equities post the Federal Reserve meeting signals that investors are starting to question the narrative of prolonged high interest rates. Although he accurately predicted the stock market downturn in 2022, Wilson failed to anticipate the subsequent rally in 2023.

Morgan Stanley

In contrast, Savita Subramanian from Bank of America remains optimistic about the prospects of the equity markets even in the presence of elevated interest rates. She points out that a notable shift has occurred, with 50% more large-cap companies transitioning into small caps, indicating that higher capital costs have led to the survival of stronger companies. Subramanian contends that this attrition has left the S&P 500 in a robust position.

Furthermore, Subramanian supports her bullish outlook by referencing historical data. She notes that between 1985 and 2005, the S&P 500 achieved an annualized return of 15% while real rates stood at 3.5%. This historical perspective suggests that, despite higher interest rates, equities have the potential to deliver substantial returns. The divergent opinions between Wilson and Subramanian underscore the ongoing debate in the financial world regarding the intricate relationship between interest rates and equity market performance. Investors face the challenge of interpreting these dynamics to make well-informed decisions about their portfolios.

Subramanian emerged as one of the early sell-side strategists to adopt a positive stance on US stocks this year, adjusting her position after missing the initial rally in the first half of 2023. She revised her year-end S&P 500 forecast twice since May and accurately predicted the stock market downturn of the previous year. US equities faced additional declines on Monday as bond yields rose, diminishing the appeal of risk assets. These setbacks occurred after US stocks concluded their most challenging month of the year on Friday, marked by weeks of selling driven by concerns over the impact of tight monetary policies on economic growth.

While the recent turbulence has validated the predictions of some equity bears whose earlier gloomy forecasts didn’t materialize in the first half of the year, optimists argue that the losses are part of a typical seasonal dip. They point to discounted stocks and the upcoming earnings season as potential catalysts for a year-end rally. Goldman Sachs Group Inc. mentioned on Monday that the selloff has resulted in historically attractive valuations for technology stocks, especially considering that earnings estimates are still on the rise. This suggests the possibility of a resurgence in the robust bullish run witnessed earlier in the year.

Bank of America remains optimistic amid the prevailing somber sentiment. The bank’s sell-side indicator, a contrarian sentiment gauge reflecting sell-side strategists’ recommended equity allocations, maintained a level in September that has historically preceded gains 95% of the time. According to BofA, the current bearish and uncertain atmosphere on Wall Street presents an opportunity to buy stocks. In their words on Monday, “Wall Street is bearish, conviction-less and stuck. Buy stocks, sell bonds.”