Here’s The Biggest Risk For The Stock Market This Year, According To Morgan Stanley Experts

Unprecedented spending by both lawmakers and the Federal Reserve to stave off a pandemic-induced market crash helped drive stocks to new highs last year, but Morgan Stanley experts are worried that the unintended consequences of extra cash and pent-up demand once the pandemic subsides could tank markets this year–quickly and abruptly.

The biggest market surprise of 2021 could be "higher inflation than many, including the Fed, expect," Morgan Stanley analysts said in a note on Monday, arguing that the Fed's massive spending during the pandemic has moved beyond simply filling holes left by crises and is instead "creating newfound spending that led to the fastest economic recovery on record." By using its cash reserves to buy back some $1 trillion in securities, the Fed has created a market that's awash with cash, which typically helps drive inflation, and Morgan Stanley warns that influx could drive up prices once the pandemic subsides and companies scramble to meet pent-up consumer demand. Within the stock market, the inflation risk is greatest for industries "destroyed" by the pandemic and "ill-prepared for what could be a surge in demand later this year," the analysts said, pointing to restaurants, travel and other consumer and business-related firms that could be forced to drive up prices if they're unable to meet post-Covid demand. The best inflation hedges in the medium-term are stocks and commodities, the investment bank notes, but inflation can be "kryptonite" for longer-term bonds, which would ultimately have a short-term negative impact on "all stocks, should that adjustment happen abruptly." Ultimately, Morgan Stanley estimates firms in the S&P 500 could be in for an average 18% haircut in their valuations, relative to earnings, if the yield on 10-year U.S. Treasurys readjusts to match current market fundamentals–an increase the analysts said is "unlikely" but shouldn't be entirely ruled out. Meanwhile, Adam Crisafulli, the founder of Vital Knowledge Media, estimates that the influx in Fed and government spending helped boost valuation multiples in the S&P by a lofty 16%–more than the index's 14% gain last year.

"With global GDP output already back to pre-pandemic levels and the economy not yet even close to fully reopened, we think the risk for more acute price spikes is greater than appreciated," Morgan Stanley equity strategists led by Michael J. Wilson said, noting that the rapid rise of bitcoin and other cryptocurrencies is a sign markets are already starting to think currencies like the dollar could be in for an unexpected crash. "That adjustment in rates is only a matter of time, and it's likely to happen quickly and without warning."

The pandemic was "perversely" positive for large companies, Crisafulli said Monday. The S&P's 14% gain pales in comparison to the larger and tech-heavy Nasdaq's eye-popping 40% surge last year, as firms–boosted by government spending–utilized existing resources and scale "to evolve and preserve their earnings." As a result, Crisafulli agrees that rates should be the "big macroeconomic story of 2021" as a waning pandemic unearths upward price pressure.

$120 billion. That's how much the Federal Reserve is spending each month buying back Treasurys and mortgage-backed securities after initiating a massive $700 billion asset purchase program in March. The U.S. federal government, meanwhile, has authorized some $3.5 trillion in spending to shore up the economic recovery as a result of the pandemic.

Chicago Fed President Charles Evans said Monday he had "full confidence" the Fed was well-positioned to help spur a robust economic recovery with its current asset purchase program, and he further noted that the central bank was open to adjusting its rate of purchases once springtime hits. "Economic agents should be prepared for a period of very low interest rates and an expansion of our balance sheet," Evans said.

What To Watch For

President-elect Joe Biden nominated former Fed Chair Janet Yellen to head up the Treasury Department, a sign the federal government could work more closely with the Fed to help battle economic inequalities through programs such as universal basic income, Morgan Stanley notes. "That is exactly the sea of change that can lead to unexpected outcomes in the financial markets," the investment bank says.

The US Government Has Authorized More Than $10,000 Per Person In Stimulus Spending This Year (Forbes)