- Morgan Stanley’s CIO said bond yields had surpassed levels that support high stock valuations.
- Investors should focus on a select few sectors in the market, Mike Wilson says.
- The bank said it favored key sectors with strong earnings, like financials and media.
The bond market is sending investors a clear signal about where to invest their cash, according to Morgan Stanley’s top stock strategist.
Mike Wilson, the CIO and chief US equity strategist at the investment bank, said he believes bond yields have climbed past a key level in recent weeks that suggests investors should narrow their focus on select areas of the market.
The yield on the benchmark 10-year US Treasury ticked past 4.5% on Thursday, a psychological threshold for investors that suggests interest rate expectations are elevated.
Yields surpassing that threshold is a sign that rates are no longer supportive of high valuations — which was key to the stock market’s outsize returns in recent years, Wilson said in a recent episode on Morgan Stanley’s “Thoughts on the Market” podcast.
“In December we decided that 4%-4.5% was a sweet spot for equity multiples, assuming growth and earnings remained on track. We view 4.5% as a key level for equity valuations,” Wilson said.
“Instead, earnings are now the primary driver of returns, and that is likely to remain the case for the foreseeable future,” he added.
That shift has led Morgan Stanley to favor large-cap quality stocks, Wilson said, as well as areas of the market with strong breadth in earnings revisions.
He pointed to sectors like financials and media & entertainment, which have outperformed the market in recent months. The Financial Select Sector SPDR Fund and the Communications Services Select Sector SPDR Fund are both up 7% year-to-date, ahead of the S&P 500, which has climbed 4% since the start of the year.
Wilson also said the bank preferred software stocks over semiconductor stocks, as well as stocks in the services sector over the goods sector, due to earnings strength.
Among defensive stocks, which investors buy to buffer against macroeconomic uncertainty, the bank favored utilities over investments like real estate investment trusts and healthcare stocks.
“While we’ve seen outperformance in all these trades, we’re sticking with them for now. We retain an overriding preference for large-cap quality, unless 10-year Treasury yields fall sustainably below 4.5%, without a meaningful degradation in growth,” Wilson said.
Yields have trended higher since the start of the year, largely due to higher inflation and interest-rate expectations in the economy. The yield on the 10-year Treasury note, for instance, spiked in the weeks leading up to Donald Trump’s inauguration, a sign that investors anticipate that some of the president’s policies — like his plan to levy tariffs on Mexico and Canada — could lead to higher inflation.
The outlook for Fed interest rate cuts this year, meanwhile, has dimmed, especially given that inflation has been ticking up in recent months.
Investors are largely expecting the central bank to keep interest rates unchanged for the next several policy meetings, according to the CME FedWatch tool. Morgan Stanley only foresees one 25 basis-point rate cut in June as likely this year, Wilson added.