MSSB: Recessionary risks will drag down equities

The following is an excerpt of commentary from the January meeting of the Global Investment Committee, which is made up of senior professionals from Morgan Stanley LLC Research, Morgan Stanley Smith Barney, Citi Investment Research & Analysis and outside financial market experts. To read the full commentary, click here.

Looking forward, we believe the backdrop for equity market performance will remain challenging, as the odds of recession in developed economies in the near term are uncomfortably high. Indeed, it appears that a downturn in economic activity in the Euro Zone already has begun and, given the interconnections within the global economy, it is difficult to envision the downturn remaining confined to one region. History indicates that a recessionary backdrop poses significant challenges to equity market performance, at least until investors start to anticipate the end of the downturn. On average, US recessions have lasted about 15 months. The equity market typically declines during recessions and bottoms, on average, about five months before the recession ends.

LOWER EXPECTATIONS. Although there is no precise way of determining how much of an earnings shortfall already is priced in the market, the answer to that question may well hold the key to performance in the year ahead. The latest estimates for earnings-per-share growth in 2012 for the companies in the S&P 500 Index from Morgan Stanley and Citi strategists are modest to say the least—just 3% and 2%, respectively, versus the 10% consensus of Wall Street analysts. Even small, single-digit estimates may prove to be too optimistic in a recessionary environment, as earnings typically decline during economic downturns. The outlook isn’t any better on a global level. Consensus expectations for global EPS growth in 2012 are also at 10%. Robert Buckland, global equity strategist for Citi Investment Research & Analysis, expects flat EPS growth this year. How-ever, he believes, at current levels, the stock market is priced for an economic recession and an earnings performance that is well below his below-consensus estimate. On balance, we believe that the current backdrop warrants a small tactical underweight allocation to equities.

EMERGING MARKETS. Although recessionary environments typically result in broad equity market declines, performance is likely to vary across regions. With this in mind, we favor emerging markets, where valuations are relatively low and there is scope for fiscal and monetary policy changes to support economic growth. We also note that the relatively high 3.1% dividend yield in emerging markets and the 8.4% dividend-per-share growth rate (annualized over the past five years) are often-overlooked attributes of this sector. Within developed markets, we favor the US over Europe and Japan. Although valuations in those two regions are tempting, economic headwinds appear to be structural as well as cyclical. This is likely to limit the upside for equity markets.

U.S. PREFERENCES. Within the US stock market, we favor large-cap stocks—a tactical position we took last April largely based on relative valuation, which had reached extreme readings. Although the valuation advantage is no longer extreme, it remains elevated by histori-cal standards. Moreover, large-cap stocks typically outperform during adverse market conditions. At the style level, we prefer growth stocks over value stocks, which is a preference we initiated in July 2010. By historical standards, value stocks continue to appear expensive relative to growth stocks, though, here too, relative valuations are no longer at extreme readings. During periods of decelerating corporate earnings, growth stocks—companies that have the ability to deliver relatively stable earnings growth regardless of the economic backdrop or those expected to post above-average earnings growth—typically outperform.