Morgan Stanley: With yields falling, these stocks that act like bonds may be a good bet

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Morgan Stanley’s strategists see even more outperformance in stocks that behave like bonds, as yields continue to recede on weak economic outlooks.

Two such sectors include real estate investment trusts and utilities, which tend to rise and fall in tandem with bond prices, chief strategist Michael Wilson told clients on Monday. Bond prices move opposite yields.

Bond yields from around the world have staged a dramatic downshift in recent weeks following the Federal Reserve’s March decision to hold interest rates steady. Chairman Jerome Powell also detailed the central bank’s reduced outlook on American production, described tame inflation and suggested that it may not have to raise rates in 2019.

“We maintain our view that the reason for the Fed’s pivot is a deterioration in economic outlook that has elevated the risk of the economy entering a recession sooner than the average market participant might expect,” Wilson wrote in his note. “If this view proves to be correct, it is reasonable to expect the Fed to actually begin cutting rates.”

Though the Fed has yet to telegraph rate cuts, investors flooded the bond market, pushing down long-term debt yields. Though Treasurys have long been considered a safer alternative to stocks in times of economic trouble, diminished inflation expectations also buoy bond prices. Inflation threatens bond prices as rising costs chip away at the value of fixed payouts.

The yield on the benchmark 10-year Treasury note — a barometer for rates on mortgages and student debt — is down about 90 basis points over the past year.

That has goosed REIT and utilities stocks, which have outperformed the broader market over the past 12 months. Viewed as bond proxies, REITs and utilities remain the No. 1 and No. 2 sectors in the S&P 500 over the last year with gains of 17 percent and 15 percent, respectively.

30-year fixed mortgage rate vs. 10-year Treasury note yield

The emergence of the Fed’s dovish tone has helped real estate shares, which had been under pressure amid expectations for higher interest rates. Higher rates not only reduced home sales through more expensive mortgage rates, but also undercut the industry’s beloved dividend payments, a trait REITs share with utilities.

“REITs and Utilities appear to have the most consistently positive residual return correlations with bonds in the post crisis era,” Wilson continued. “Investors need look no further than the large relative outperformance of Utilities and REITs since last summer to see this relative benefit of positive bond correlations.”