Morgan Stanley strategists say the easy returns are over for U.S. equities, credits and Treasuries, but see value in European and Japanese stocks in 2022.

The current market cycle has been hot and fast. So much so, in fact, that investors are now confronting a very different dynamic for the year ahead—early-cycle timing, midcycle conditions and late-cycle valuations, with exuberance to boot.

“As unprecedented fiscal and monetary policy support fades, fundamentals dominate,” says Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research. 

Inflation in Major Markets Will ‘Peak Then Retreat’

While inflation will be at levels higher than many investors have seen before, Morgan Stanley economists believe prices will soon “peak then retreat” as supply chain pressures ease and prices for many commodities normalize. To that end, central banks likely won’t take drastic measures to raise rates and pump the brakes on growth. That said, investors have an almost Pavlovian response to any talk of tightening, which is just one of many reasons to approach U.S. equities and Treasuries with caution.

Emerging markets seem primed for growth, but it’s too early to be all-out bullish those markets, say strategists.  “In China, headwinds from energy prices, regulation and COVID remain, and our expectations don’t call for major policy easing, at least not yet,” says Sheets. “The one exception is high-yield credit in China, where we think that the market is underestimating the resolve and ability of policymakers to control the disruption in the property sector.”

Here are five highlights of the 2022 global investment outlook.

1. Time to Lighten Up on U.S. Stocks?

In a view that is “most likely to raise eyebrows,” says Sheets, strategists think the S&P 500 index could decline 5% in 2022 while other developed markets could end the year higher. They recommend underweighting U.S. stocks to account for high valuations and more catch-up potential and less volatility elsewhere in the world.

“The persistent price outperformance of U.S. stocks for much of the last decade has been driven by superior and more durable earnings trends, but uncertainties are mounting around cost pressures, supply issues, policy uncertainty and tax changes,” says Mike Wilson, Chief U.S. Equity Strategist.

2. European and Japanese Stocks Are Calling

In contrast to U.S. equities, stock markets in Europe and Japan are more reasonably priced and geared toward growth. “And thanks to reduced inflationary pressures, their central banks should be exceedingly patient,” says Sheets, whose team recommends investors overweight both markets.

In Japan, equities continue to deliver improving returns on equity, while economic stimulus, business reopenings and strong global capex all suggest that Japan’s stock market could appreciate 12% next year.

Meanwhile, the MSCI Europe index has enjoyed its best period of relative outperformance in 20 years compared to the rest of the world, and that pattern should continue thanks to increased mergers and acquisitions, buyback activity and changes in investor positioning since many global portfolios had been underexposed to the region.

“Our combined earnings and valuation assumptions suggest that European stocks can deliver an 8% price return and double-digit total return,” says Graham Secker, Chief European Equity strategist. The team’s top sector picks include autos, energy and financials, which should all benefit from the move up in real yields.

3. Stock Selection Could Matter More Than Style and Sector

Morgan Stanley strategists believe health care, financials and secular technology companies could see upside in the year ahead. Consumer goods and cyclical technology stocks could lag as supply and demand dynamics settle into a more normal pattern.

Even so, relative to other points in this market cycle, there are fewer opportunities for investors to take advantage of big swings in styles and sectors.

“In our view, the economic and political environment has been permanently altered from its pre-COVID days, although the changes are not necessarily due to the pandemic itself,” says Wilson. The eventual outcome should mean greater investment and productivity, but that could take years to play out. “That breeds higher uncertainty and dispersion, making stock picking more important than ever in the year ahead,” Wilson says.

4. Government Bonds Are All Over the Map

Central banks in developed markets responded to the COVID-19 pandemic with near-uniform interest policies and a deluge of liquidity.

In 2022, however, bond markets will need to make sense of differentiated policies. “Some policies, such as in the UK and Canada, will be aimed at outright tightening financial conditions, while others will attempt to ease financial conditions further, albeit at a slower pace, or maintain accommodative financial conditions,” says Matthew Hornbach, Global Head of Macro Strategy.

Morgan Stanley strategists recommend underweighting U.S. Treasuries—particularly those with intermediate maturities—in expectation of the 10-year Treasury moving past 2% by the end of 2022. They also see agency mortgage-backed securities coming under pressure from rich valuations and higher volatility.

Local emerging market debt is starting to look interesting, say strategists, but investors should be patient. “With expectations that the U.S. dollar and real yields rise to start the year, we think that investors will get a better entry point later in the year,” says Hornbach, whose team thinks the U.S. dollar will strengthen in the first half of the year, but lose steam in the second half.

5. In Commodities, Oil Springs Ahead

For the first time in a decade, commodities outperformed the S&P 500 in 2021, for a variety of reasons. Gold prices have been supported by stagflation concerns and the pushing out of rate hike expectations, while base metals have benefited from the combination of constrained supply and rising demand.

Looking ahead, metals may lose their luster as high real yields weigh on gold prices, while copper and zinc prices soften with better supply. Aluminum remains a top pick for the strategists, who point to cyclical and structural factors.

Within commodities, oil offers the best combination of valuations and fundamentals, says Chief Commodity Strategist Martijn Rats. His team believes oil could top $90 a barrel in 2022 as rising demand meets relatively spare capacity.