While Goldman’s permabullish chief equity strategist David Kostin is only just now catching down to where other prominent Wall Street bears have been for weeks and on Friday finally capitulated, cutting his year-end S&P target (which he hiked just three months ago) from 5,100 to 4,900 while warning that in a recession the broad index could plunge as low as 3,600…
… Morgan Stanley’s chief equity strategist Michael Wilson – whom we dubbed last year as Wall Street’s biggest bear and who has long been pounding the table on his 4,400 year-end S&P target – has the luxury of being miles ahead of his competition (which only now is goalseeking crude rationalizations to cut formerly euphoric price targets without actually looking ahead at what is coming), and in his latest Weekly Warm Up note (available to pro subs in the usual place) writes what we have been saying for months, namely that while last week’s inflation release got all the attention, it will mark a top in the market’s obsession with the Fed and rates. Instead, what markets will focus on from now on is how big the coming slowdown/recession will be, or as Wilson puts it, “while these still matter, the duration and depth of this incomplete correction will be determined by how much growth disappoints, in our view.”
Elaborating on his view why the CPI is “Yesterday’s News”, Wilson writes that while there are many moving parts in any market environment, “investors often become infatuated with one in particular” and last Thursday’s CPI release for January was one of those times: “For the days leading into it, every conversation with investors, traders and the media seemed obsessed with the number and whether markets were appropriately priced. For the inflation bulls, the release did not disappoint, coming in significantly stronger than expected, with the breadth of the internals just as hot. Markets reacted appropriately to the surprise with yields surging higher at both the front and back end of the curve. Additional hawkishness got priced in quickly as markets concluded the Fed was falling even further behind the curve given its current policy of still adding accommodation. Talk increased of an emergency Fed meeting to discuss the possible immediate cessation of QE and/or an intrameeting rate hike. By the end of the day on Thursday, markets had priced in a 90% chance of a 50bps hike at the March meeting and 6-7 25bps worth of hikes by the end of the year, or approximately 160- 165bps (Exhibit 1). Balance sheet run off, or QT, is also expected to begin by the middle of this year at the rate of $80B/month.”
Of course, none of this is surprising to Wilson, who first started talking about “Fire and Ice” last September, when he laid out his view that the Fed would have to go faster than expected to fight the building inflationary pressure, which coming at a time when one bank after another was pumping permabullish drivel (here’s looking at you JPMorgan), was met with quite a bit of skepticism. And, as Wilson adds tongue-in-cheek, for a good part of the fall, the markets disagreed too. Some of this was due to the fact that most investors and markets like to see the hard data before positioning for it. The other reason is likely due to how the Fed, and other central banks, has behaved since the financial crisis with their ultra dovish policy bias. In any case, fast forward to today and as the MS strategist gloats, “the data is irrefutable. Doves are quickly going extinct.“
This, in turn, brings us to another key point we have been pounding on the table: while the Fed will certainly try to hike until it sees “whites in the eyes” of the market, the economy will slide into recession long before the Fed can contain inflation. This is also the central concern in Wilson’s report, because as we notes, while he doesn’t doubt the Fed and other central banks’ resolve to try and get inflation back under control, “the market is now “all in” on the idea they will do their job to fight inflation.” However, Wilson – like this website – finds himself “skeptical” they will be able to get as much policy tightening done as is now expected, and priced. Furthermore, taking a direct shot at the prevailing stupidity of the sellside herd, Wilson then writes that “when something is this obvious and consensus, it’s usually time to start focusing on something else, or at least looking at the situation with a bit more of a discerning eye and asking has it gone too far at this point.”
So while Wilson remains solidly in the inflation camp and has been since April 2020 when we were at the depths of the COVID recession, he thinks “last week may have marked a short-term top in terms of the rate of change in the CPI” and one of his favorite leading indicators is telling us as much. To wit: Companies are saying now that they have a lot of cost pressures right now but they have been able to pass it on…hence, why we have inflation. However, the PPI is now rolling over relative to the CPI and that spread tends to line up with the CPI.
Furthermore, the price paid component of the ISM mfg survey also appears to have peaked and tends to coincide with the PPI-CPI spread.
Wilson’s bottom line: while the level of inflation is likely to remain well above the Fed’s target in the foreseeable future, the rate of change may have peaked, which could reduce investors’, and the market’s, current obsession with it.
But if investors shouldn’t focus on inflation so much anymore, what should they focus on instead?
Well, as regular readers know very well, we have long been saying that what matters now for risk – and the Fed – is how quickly the US slides into recession which will end any future tightening. And now Wilson agrees with us, writing that he thinks “equity markets will now begin to focus on growth, or the lack thereof. In short, one should begin to worry about the Ice now that Fire is generally appreciated.”
One of the reasons Wilson – like us – is skeptical that the Fed and other central banks will be able to deliver on the policy tightening now expected is the fact that growth is already slowing, an unusual circumstance at the beginning of any monetary policy tightening cycle, and especially one that is so ambitious.
And another place where Morgan Stanley’s thinking is identical to ours – the culprit behind the slowdown, which we agree is the collapsing purchasing power of the US consumer. As Wilson puts it, “whether it’s the payback in demand, or sharp decline in real personal disposable income, the rate of consumption is likely to disappoint expectations in the first half of 2022. Furthermore, this weaker consumption is arriving just as supply chains are finally loosening up, something that is likely to be aided by the end of Omicron and the labor shortages it has created in the transportation and logistics industries.” In that regard, Friday’s devastating Consumer Confidence release was the more important macro data point of the week, not the CPI, according to Morgan Stanley.
In any case, markets did seem to agree with Friday’s sell-off being quite broad and focused on the more cyclical sectors and stocks. Defensives and Energy carried the day given the rising tensions in Russia/Ukraine situation. While many strategists and investors will likely chalk up Friday’s weak equity market to this risk, Wilson thinks ignoring the extraordinarily weak consumer confidence number would be a big mistake. This doesn’t mean a possible Russian invasion of Ukraine is unimportant, but it does perhaps change one’s interpretation of what it means for markets.
Summarizing his view, Wilson writes that in his view, “it materially increases the odds of a polar vortex for the economy and earnings.” Meanwhile, if it doesn’t happen, we’ll just experience a colder than normal winter and spring. If he is wrong and growth reaccelerates, Wilson believes that markets can find some footing but it will also allow the Fed and other central banks to keep going hard until they likely slow things enough to get inflation back near its goal of 2-3%, which a long way from here.
Meanwhile, according to Morgan Stanley’s Quantitative and Derivatives Strategy (QDS) team, led by Chris Metli, the market is already starting to worry more about growth than inflation/Fed (Exhibit 4 and Exhibit 5).
As they put it, “If the equity market is going to hold up, growth will need to match the Fed’s new level of hawkishness. But, that’s a high bar now… The interplay between economic growth and financial condition drivers can be seen in the correlations of S&P 500 to yields. Yes the S&P 500 is negatively correlated to real yields (i.e. Fed tightening –> lower equities), but it’s also more positively correlated to breakevens than normal (i.e. stocks still go up when breakevens rise) – which can be considered remarkable given what the implications of higher inflation are for the Fed and financial conditions. But it also highlights that the market understands what the Fed is going to do – it’s just a debate over the degree. The market is much more uncertain about what economic growth will be.”
From Wilson’s standpoint, the set up is becoming more clear: stocks have been de-rating for almost a year now as investors began to anticipate the inevitable tightening from the Fed given the robustness of the recovery and building imbalances. As he noted previously, the MS strategist believes that “this de-rating is about 80% done at the stock level with the S&P 500 P/E still about 10% too high (19.5x versus our 18x target). In other words, the de-rating is more complete at the stock level than at the index level, at least for the high quality S&P 500. This is the way it usually works with the best companies seeing it last, a phase we think began a few weeks ago with the market finally acknowledging the Fed’s need, and desire, to tighten a lot.”
But here a big caveat appears: this de-rating assumes growth stays solid and doesn’t fall below trend, or worse. That assumption was pretty much a given for most investors… until now. Wilson’s attention – like ours – has always been on oncoming risk – the Ice, but it shifted more aggressively about a month ago when the Fed minutes came out in early January. As such, not if but when growth begins to disappoint, economically sensitive stocks, or cyclicals, will underperform the most. Of course, Energy is a special case given the state of affairs in Russia/Ukraine although ironically, Morgan Stanley believes that energy stocks could be most at risk for a correction should a potential invasion happen in a way that leads to an oil and nat gas spike. “Such a spike would destroy demand, in our view, and perhaps tip several economies into an outright recession – the polar vortex.”
This is precisely what we noted earlier today.
Where in the cycle are we: energy stocks are now dropping on higher commodity prices which are now viewed as recession triggers
— zerohedge (@zerohedge) February 14, 2022
Meanwhile, as Wilson’s fundamental narrative of Fire and Ice plays out , he urges clients to keep a close eye on the technicals to try and determine when the risk reward has improved enough to get more bullish. Unfortunately, he notes, “the technical picture has broken down and does not look ready to reverse.” Just using a simple 50- and 200-day moving average, the Russell and Nasdaq/NDX appear broken, trading well below their respective 200 days with a negatively sloping 50 day. Last week, the Nasdaq/NDX was rejected once again in its second attempt to reclaim the 200 day, a bad sign in our view. Meanwhile, the Russell hasn’t had a weekly close above it’s 200 day since Thanksgiving. Finally, the S&P 500 had its second weekly close below its 200-day moving average on Friday after managing to claw back from January’s drubbing.
Normally, Morgan Stanley would be looking at such breaks as reason to start getting positive. However, given the bank’s fundamental outlook for much slower growth in the first half of the year, and the fact that these indices remain so far extended above their 200 week moving averages, Wilson says he will be patient to try and call the end to this correction that began 6 months ago. At a mininum, he sees all of the major averages taking out January’s lows given the lack of any positive divergences on that initial sell off.
Finally, breadth is another important variable Wilson is watching to indicate if the technical picture is improving. This also remains elusive thus far and supports a view that growth is still likely to get worse before it gets better. The good news is that breadth is trying to turn up…
… but at current levels suggests another 3 percent downside. Wilson says he will be watching this and other measures of breadth as key barometers of what’s actually priced into the index and when it’s time to pivot more constructively.
Bottom line: stocks may rebound, but it won’t be for a long time.
The full Michael Wilson note is available to pro subs.