Stock-market outlook: 3 trends that will dictate rest of 2019 prices

“Defensive but not bearish” is how Morgan Stanley's cross-asset strategists are approaching the stock market for the rest of the year.Their US cycle indicator of macro, credit, and corporate conditions has slumped into “downturn” mode for the first time since 2007, warranting this cautious approach.Morgan Stanley lays out three trends that will affect how markets trade for the rest of 2019, how they expect each one to play out, and how to invest for each predicted scenario.Visit Business Insider's homepage for more stories.Morgan Stanley's cross-asset strategists are convinced it's time to be defensive, but not yet flat-out bearish, on the stock market.For investors who buy into their outlook, this posture is intended to profit from whatever gains remain in this bull market and still be adequately prepared for the next downturn.They are specifically cautious about US stocks, and recommend that investors take risks more aggressively in other markets. The basis of this call is that their US cycle indicator of macro, corporate, and credit conditions is in “downturn” mode for the first time since 2007.“'Downturn' historically sees worse-than-average returns for risk assets, but not necessarily immediate losses, at least for equities,” Andrew Sheets, Morgan Stanley's chief cross-asset strategist, said in a recent note to clients.Sheets laid out the three “gaps” that matter most for how markets will perform in the second half of the year, when this downturn could start materializing. He included investing recommendations for Morgan Stanley's views on how these trends will play out. All quotes below are attributed to Sheets.1. The output gap narrows.The difference between the US economy's current output and its potential capacity — otherwise known as the output gap — is still wide enough that inflation is not a big headache for markets.Instead, traders have priced in a so-called Goldilocks scenario in which the Federal Reserve keeps interest rates steady and probably cuts them sometime during the next 12 months.Morgan Stanley says the opposite scenario is more likely: They expect output to rise even closer to its potential, putting pressure on the Fed to make policy decisions that won't be palatable to stock-market investors.“With US stocks expensive but US Treasuries offering higher real yields than other DM markets, we are underweight US equities, underweight US credit and overweight high-quality US bonds (Treasuries, agency mortgages).”2. The gap between the US economy and the rest of the world reverses.Morgan Stanley expects Europe and China to benefit from easier fiscal stimulus, putting their growth ahead of the US's. They prefer taking risk outside the US for this reason.“Valuations on stocks outside the US look better, especially in Japan, where we think markets unappreciated the corporate reform story. We lower EM equities to 'equal-weight', and make Japan our most-preferred equity region.”3. The price-versus-fundamentals gap collapses.Many stock markets have rallied this year even though analysts have lowered their earnings estimates, Morgan Stanley said. The rallies have also happened at the expense of value stocks.“Look for relative value in pricing disconnects: We like owning European value vs. growth and India and Brazil equities over Taiwan and Korea. We like China and Mexico rates.”