Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and Chief U.S. Equity Strategist. Today on the podcast, I'll be discussing how equity markets have traded post the election and how this fits with our thinking.
It's Tuesday, December 10th at 1130 a.m. in New York. So let's get after it.
Post the election, our focus has been on the potential for a rebound in animal spirits like we observed following the 2016 election. During that historical period. We saw a broad-based surge in corporate, consumer, and investor confidence as the sentiment analysis we've done shows. So far over the last month, sentiment data has reflected a more measured level of optimism, led by small business confidence, while services-related businesses'outlooks were actually tempered somewhat. Our assessment of the details of these surveys and commentary from corporates suggests that consumers and companies are feeling more optimistic heading into 2025. But the uncertainty around tariffs and the still elevated price levels are likely holding back the type of exuberance we saw post the 2016 election.
In 2016, we were also coming out of an industrial manufacturing downturn, which was then aided by aggressive China stimulus. Due to that downturn, interest rates were much lower globally, and sovereign deficits and balance sheets were in much better shape to absorb reflationary-type policies like tax cuts and deregulation. As a result, the equity market almost immediately embraced an expansionary fiscal agenda that was interpreted as being pro-growth.
Today, that policy agenda appears to be less front-footed in this regard, perhaps due to some of these constraints. Nevertheless, these dynamics are still supportive of our preference for more cyclical sectors. However, given the stickiness of interest rates, it also makes sense to remain up the quality curve within cyclicals and constructively focused on sectors with clearer deregulation tailwinds.
As a result, financials remain our preferred overweight, followed by software, utilities, and industrials. On the topic of interest rates, we find it interesting that the correlation of S&P 500 returns versus the change in bond yields remains in positive territory. In other words, good macro data is good for equity returns. Furthermore, there's a clear bifurcation in terms of this correlation between cyclical and defensive sectors. Cyclical sectors are showing a positive correlation to rates with one exception of materials, while defensive cohorts are showing a negative correlation except for utilities.
In our view, this is a sign that cyclicals in the market overall still like stronger macro data, even if it comes amid higher yields. Having said that, there is a point where this dynamic would likely reverse if interest rates rise due to less dovish monetary policy or an increase in the term premium. In April of this year, that level was 4.5% on the 10-year Treasury yield when growth and inflation drove the term premium higher. For now, rates remain contained well below that threshold, and the term premium is close to zero. On the flip side, a material decline in yields due to weakness in the macro growth data would also hurt cyclical stocks disproportionately, leaving 4% to 4.5% on the 10-year Treasury yield as the sweet spot for equity valuations.
Yields below that range can certainly be tolerated by equities, assuming the driver is fed rate cuts in the absence of a material slowdown in growth. Yields above that range can also be tolerated if the pace of the rate rise is measured and the driver is stronger nominal growth versus more hawkish Fed or rising inflation. Finally, as we approach year-end, December seasonality is likely to be a focal point for investors. Over the past 45 years, the S&P 500's median return over the month of December is 1.5%, and the index has a positive return 73% of the time. Notably, almost all of that performance comes in the second half of the month.
These trends are directionally consistent for the Russell 2000 small cap index, except that it's even stronger at about 2.5%. This performance could be further enhanced by the larger post-election spike in small business confidence mentioned earlier. Thanks for listening. If you enjoy the podcast, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today. The preceding content is informational only and based on information available when created.
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