Amid ongoing sell-offs in global bond markets, the AI-driven rally in U.S. stocks is facing a significant test. Mike Wilson, Chief U.S. Equity Strategist at Morgan Stanley, cautions that if bond market volatility intensifies and long-term interest rates continue to rise, the stock market could experience its first substantial correction since hitting a low point at the end of March this year.
In their latest report, Wilson's team stated, "If the bond market becomes more turbulent and long-term rates keep climbing, we anticipate the stock market will undergo a notable adjustment from the lows seen in late March." Late last week, the S&P 500 retreated from its record highs, and futures indicate that U.S. stocks are poised to extend losses on Monday.
The primary pressure on market sentiment stems from rising energy prices due to tensions involving Iran, reigniting inflation concerns and triggering a broad sell-off in U.S. Treasuries. As of last Friday, the yield on the 30-year U.S. Treasury had climbed to its highest level in nearly three years, while the 10-year Treasury yield also surpassed a key psychological threshold. Concurrently, Japanese government bond yields surged to multi-decade highs, significantly increasing interconnected risks across global bond markets.
Wilson analyzes that the sharp rise in U.S. Treasury yields, coupled with the Federal Reserve's recent hawkish signals, reflects two macroeconomic realities: first, crude oil prices remain elevated due to the Iran conflict, and second, the U.S. economic fundamentals remain robust. He added that for bond markets to see a genuine decline in rates, what is needed is not a brief technical correction but a lasting resolution to the Iran conflict. Until then, the high volatility environment in bond markets is likely to persist, putting pressure on stock valuations.
Despite heightened short-term risks, Wilson's team has not altered its long-term bullish stance on U.S. stocks. In fact, they recently raised their 12-month target for the S&P 500 to 8,300 points, based on the premise that U.S. companies are experiencing the strongest profit growth in over two decades, excluding periods of recovery from major shocks.
Wilson emphasized that investors generally underestimate the breadth of this profit growth beyond AI beneficiaries. Profit recovery in traditional sectors such as healthcare, industrials, and finance is accelerating, yet market risk appetite for these potential beneficiaries of "profit diffusion" remains significantly insufficient.
Wilson concluded, "While the breadth of the profit recovery is expanding, market participants are largely unprepared for it. Two key variables to monitor closely going forward are whether oil prices and interest rates can retreat significantly from recent highs. Only if both variables cool down can the profit diffusion rally truly accelerate."
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