Economic conditions remain favourable for S&P500 despite the view of many analysts that US stocks look overvalued.

That’s according to Morgan Stanley’s US equity strategists, who argue that competing market forces are creating a sweet spot for the US share market.

US stocks are continuing to trade at or near record highs, shrugging off a run of poor recent data which have raised doubts about the pace of economic growth.

It’s led to a stark divergence between the S&P500 and Citi’s Economic Surprise Index, a measure of the strength in key economic data points:

While the continued price growth in major tech stocks and valuation ratios which look historically high by some measures have been the main talking points around US stocks, Morgan Stanley’s team looked at surrounding market conditions.

They noted that inflation had fallen in 2017, with May’s core CPI growth of 1.7% the lowest in two years.

However, “the breadth of factors contributing to slower inflation is striking, but there are some explanatory factors that indicate the declines are not necessarily indicative of a broadly weakening growth picture,” they said.

The analysts highlighted fundamental shifts in retail and evidence of over-supply in new housing as factors weighing on inflation, “but well identified overcapacity in one market and the continuance of a longstanding trend in the other leave us comfortable in a growth outlook sufficient to support equity markets”.

What’s more, lower inflation is unlikely to cause a drag on stocks because it means that a rise in interest rates is likely to be deferred which leaves less room for yield-seeking capital to move out of equities.

While inflation is unlikely to move to high, Morgan Stanley takes the view that broader economic health will prevent a steep fall as well.

“While core CPI may remain subdued, it is likely to stay in a stable range between 1.5%-2% in the near term which we feel is ultimately a sweet spot for equities as it may deter an aggressive policy stance from the Fed for the time being,” the analysts said.

“When core inflation starts to creep above that 2% level, equity multiples tend to contract.”

Noting the current tightness in the labour market, the analysts said that the US Federal Reserve places a bit too much emphasis on the effect of the Phillips Curve in its inflation forecasts.

The Phillips Curve plots an inverse relationship between low unemployment and high inflation.

They said that while there is some negative correlation between the two, it only applied directly to certain components of the inflation basket.

“So despite tightening labor markets, the Phillips curve alone is unlikely to be sufficient in taking inflation to 2%, given various other structural forces at play, which have weighed on inflation,” they said.

Next they looked at the Misery Index, which is the sum of the unemployment rate and inflation. Given low unemployment and low inflation, the Misery Index is at the narrow end of its range and when the happens, stocks tend to stay elevated:

Add it all up, and the supportive economic conditions can go some way to explaining the strong rise in US stocks this year.

The Morgan Stanley team added that stocks are also benefiting from a policy “sweet spot” in terms of the Trump administration’s pro-growth agenda.

While markets initially rose after the November elections on the back of Trump’s pledges to reduce corporate tax and boost infrastructure spending, policy gridlock has pushed back the time frame for both of those initiatives.

“The lack of progress on the growth agenda caused long-term interest rates to settle down after a sharp spike late last year, allowing equity valuations to expand — a key part of our more bullish than consensus 2017 outlook,” Morgan Stanley said.

In fact, if either of those measures are enacted it could give rise to the US Fed ramping up the pace of rate hikes, which would negatively effect equities.

Conversely, the strategists added that other Trump proposals which would negatively affect growth — namely his protectionist stance on international trade — have also yet to come to pass.

“What we have from the Trump administration is very much a Goldilocks outcome—not too hot, which could be inflationary, nor too cold, which could be deflationary,” they said.

“Assuming earnings continue to beat expectations and grow, the Federal Reserve will not be forced to tighten too quickly and valuations can expand further, allowing equity markets to achieve our high expectations for this year.”

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