Morgan Stanley Quantifies The Probability Of A Global "Muddle Through": 37%
When it comes to attempts at predicting the future, it often appears that the most desirable outcome by everyone involved (particularly those from the status quo, which means financial institutions and media) is that of the "muddle through" which is some mythical condition in which nothing really happens, the global economy neither grows, nor implodes, and it broadly one of little excitement and volatility. While we fail to see how one can call the unprecedented market vol of the past 6 months anything even remotely resembling a muddle through, the recent quiet in the stock market, punctuated by a relentless low volume melt up has once again set market participants' minds at ease that in the absence of 30> VIX days, things may be back to "Goldilocks" days and the muddle through is once again within reach. So while the default fallback was assumed by most to be virtually assured, nobody had actually tried to map out the various outcome possibilities for the global economy. Until today, when Morgan Stanley's most recent addition, former Fed member Vince Reinhart, better known for proposing the Fed's selling of Treasury Puts to the market as a means of keeping rates at bay, together with Adam Parker, have put together a 3x3 matrix charting out the intersections between the US and European economic outcomes. Here is how Parker and Reinhart see the possibility of a global goldilocks outcome, and specifically those who position themselves with expectations of this being the default outcome: "A “muddle through” positioning is potentially dangerous: Our main message is that the muddle-through scenario might be the most plausible alternative, but its joint occurrence in the US and Europe is less likely than the result of a coin toss. Uncertainty is bad for multiples." Specifically - it is 37% (with roughly 3 significant digits of precision). That said, as was reported here early in the year, Morgan Stanley is one of the very few banks which expects an actual market decline in 2012, so bear that in mind as you read the following matrix-based analysis. Because at the end of the day everyone has an agenda.
First a summary of why Morgan Stanley is no longer its usual, cheery self:
Two core theses: Our main US economic thesis is that an economy performs poorly after a severe financial crisis. After the most recent fall, wealth creation in the US this cycle is lagging behind that seen in other financial crises. Our main US equity strategy thesis is “multiple contraction”, as low and volatile growth and the extreme interest rate environment will likely weigh on the price-to-earnings ratio for several years.
Uncertainty abounds: While it’s possible our core principles will apply for the next several years, policy decisions will immediately shape the shorter-term perceptions of the economy and equity market. The uncertainty has manifested itself in 33 daily moves in the S&P500 greater than 2% since August 1st, 2011 (Exhibit 2), versus only two such daily moves in the first 8 months of 2011. The challenge is that the unanswered policy questions are too numerous to address ead-on in a coherent manner. To show one way to think about risk, we take two issues—political decisions in the United States and Europe over the medium term—and flesh out the range of possibilities based on just these two moving parts.
While nothing new to regular readers, the global risks that Morgan Stanley sees are rather intuitive:
The most striking aspect of financial markets over the past few months has been the lack of conviction among participants. Nobody can be sure about the outlook. An investor might have been right about the economic data and savvy about near-term sentiment and still been run over by headlines from Brussels orFrankfurt or Washington. It has been helpful to our own thinking about financial markets to draw a map of risks associated with one-off political events. Unfortunately, the list of unanswered questions is long.
When will US politicians come to grips with adverse fiscal trends?
How will European officials cope with their ongoing banking and sovereign crises?
What will be the pace of European bank deleveraging?
Will Chinese authorities successfully navigate through the global economic storm?
We think these questions are too numerous to address head-on in a coherent manner. In order to show one way to think about risk, we take the first two issues—political decisions in the United States and Europe over the medium term—and flesh out the range of possibilities based on just these two moving parts. Our base case economic forecast slices through the middle of those possibilities and posits a great muddle, where important decisions may be delayed. In this scenario, 2012 may be a year to be cautiously pessimistic. Of course, we could be wrong, as there is a wide range of possible outcomes in 2012 and a high degree of uncertainty around timing. On the one hand, leaders could act decisively; on the other, they could fumble enough to make future decision-making increasingly difficult.
First, we take a stab at filling out a three-by-three contingency table of bull-bear-base cases for Europe and the US, assigning our judgment of probabilities associated with each scenario in the medium term.
Second, we sketch out the likely consequences for the US and European economies in each of these outcomes over the medium-term in 2012.
Third, we assess the implications for US equity markets by making judgment calls on S&P500 earnings and likely trading ranges.
For those wondering why politics is increasingly the dominant theme when analyzing financial outcomes, Morgan Stanley explains by presenting the various cases for the US and Europe, most of which are reliant on political choicses as input variables.
First, for America:
For the United States, if there is no coherent fiscal plan in the spring of 2013 in either the second term of a re-elected Obama administration or the first term of a new president, then fiscal policy will likely drift for four more years. In such circumstances, we think there is considerable risk that US debt will be downgraded again. In fact, in recent days increasing chatter about US government debt has surfaced, though not enough to spook markets as it did last summer.
Nonetheless, market price action might well propagate failure or success in dealing with that challenge in 2012. This raises the three distinct possibilities listed below, with our subjective assessment of the probabilities given in parentheses.
US Base Case: The muddle in the middle (50%). Our base case is an unsatisfying muddle-through in both the US and Europe over the coming months. Politicians will avert a near-term train wreck but not put the train on track toward a long-run destination. Because the US dollar, at least for now, serves as the reserve currency, financial markets may shrug off this fiscal failure episodically, than cyclically react harshly to perceptions of derailment. Our market interpretation is that there will be a lot of volatility again in 2012. Since August 1st, 2011, the S&P500 has had 33 single-day moves of more than a 2%, born of “macro uncertainty”. We think this trend likely persists (Exhibit 2) given the host of macro questions.
US Bear Case: Off the rails (35%). The election contest may sink to a sufficiently low level of discourse that markets conclude that no serious work on fiscal policy will be undertaken until at least 2013. In that case, market participants will become increasingly restive in the summer and fall, creating an environment of risk aversion that is not conducive to sustained economic expansion.
US Bull Case: Off the charts (15%). Fiscal policy in the United States is delivered inefficiently and at great cost. The election contest presents two coherent, opposing remedies that offer clarity and efficiency. The American people decide in November, and newly elected officials have a mandate to implement the preferred program in spring 2013. This would be supportive of economic growth and financial markets in 2012 as the public comes to understand that such an outcome is in train and as corporations, inspired by clarity, deploy their huge excess cash reserves in a productive direction, fueling jobs and exports.
As for Europe, seventeen nations have bound themselves in a seemingly unworkable currency union. Authorities can make up for labor immobility and price rigidity only by making it a closer fiscal union. That requires strict budget rules, pan-European issuance of government securities, and an accommodative central bank.
Europe Base Case: The muddle in the middle (60%). We do not think that authorities get to where they need to go in 2012, but our base case is that they are mostly successful in signaling in 2012 that they are on the right path in a series of unsatisfactory summit meetings. This muddle-through scenario implies a roller-coaster ride for sentiment in 2012 as European officials alternatively build and dash hopes for a definitive resolution of the banking and sovereign crises. The seven elections scheduled this year will only add to the unease.
Europe Bear Case: Off the rails (25%). Part of the reason that sovereign crises are so volatile is that regime change is always possible. In the current case, voters in the wealthy European countries might get impatient with the transfer of resources to poorer countries, leading to a break-up of the currency union and debt default by a few troubled sovereigns. Voters in the poorer countries might get impatient with the conditionality required to receive those transfers, leading to debt default and a break-up of the currency union. While this may not happen in 2012, fears of a break-up are likely to grow and roil markets. In that regard, the perceived success of debt auctions will importantly influence sentiment.
Europe Bull Case: Off the charts (15%). Elected officials may be pushed by financial markets or their own voters to be quicker and more specific in disclosing their plans for fiscal union. Presenting a comprehensive and workable package that includes a commitment from the ECB to support markets would lift confidence worldwide.
These 6 standalone scenarios are not all encompasing:
No doubt, other scenarios come to mind, and there is a large element of arbitrariness in assigning probabilities to each outcome. These probabilities can also change from day to day. The right and lower tabs in the table below give our assessment of the unconditional probabilities of these major outcomes in the United States (right tabs) and Europe (the bottom tabs). It is even more speculative to assign probabilities for their joint occurrence. The inner elements of the table give joint probabilities, where the design principle is to give equal probabilities across cases unless there is a compelling counter-argument.
Still, the warning remains, and is repeated:
The main message from our analysis (Exhibit 3) is that the muddle-through scenario might be the most plausible alternative, but its joint occurrence in the US and Europe is less likely than the result of a coin toss. We think such uncertainty will continue to beget lower multiples.
So how does all this look in chart form?
First, by outcome probability:
"We Assign a 50% Chance of a Muddle-Through Scenario in the US and a 60% Chance in Europe – but the Intersection Is Likely Less than 50-50"
We wholly acknowledge that bad news in one economy will have a negative impact on the other, so these cells are inter-dependent by definition. Further, corporate profitability is sharply impacted by big moves in the relationship between the dollar and euro, so the bear scenarios for Europe could incrementally hurt US profitability, something we will be eyeing in the near term given the dollar’s strength
Then, by scenario summary:
"Our Economic Assumptions for the US and Europe Under Nine Scenarios"
While it is always difficult to tell what is priced in at any moment, we forecast the S&P500 under each of the 9 scenarios in Exhibit 5. In our 2012 Outlook piece from Jan 2, 2012, “The 2012 Playbook”, we set our (US) Bear, Base and Bull case targets of $944, $1237 and $1450, respectively. The probability-weighted price targets for each row of Exhibit 5 (corresponding to a scenario for the US) match these unconditional price targets. Within each row, however, better or worse conditions in Europe result in conditional price targets that are above or below, respectively, their unconditional values. Thus, the Bear US/Bear Europe target in Exhibit 5 of $798 (upper left cell) is below our unconditional US Bear case target of $944, while the Bear US/Bull Europe target of $1175 (upper right cell) is above our unconditional US Bear case target.
We note that the market is only 11% below our Bull US/Base Europe price target of $1425 (bottom middle cell of Exhibit 5), as investors currently are embedding a muddle through scenario for the US economy, improving US profits, modest multiple expansion, and a “quarantined” Europe for the foreseeable future. As far as the S&P500 goes, we see the risk-reward as skewed to the negative and have a year-end 2012 price target of $1167.
Finally, this is MS' best guess of where the S&P would go in any given scenario:
We Assign Price Targets for the S&P500 Under Each of the 9 Scenarios – The Market Is Only 11% Below Our Bull US/Base Europe Scenario Price Target of 1425
Ominously, following early revisions of Q4 GDP growth by other banks, Morgan Stanley has joined the bandwagon and is already putting the possibility of a sub-muddle through outcome in the US as increasingly probably if there is follow through into Q1:
Lastly, to add to the uncertainty, the US economy is once again tracking below where it started at the beginning of the fourth quarter, as weaker than expected exports have lowered our Q4 estimate for the US GDP to 2.7% (Exhibit 6). Similar negative tracking has occurred every quarter in 2011.
Yet after all this, perhaps we should have started with Morgan Stanley's conclusion: that no matter what, it is most likely the market itself that will define what GDP is at the end of the day, confirming what everyone, even the Fed knows: that in our bizarro world, it is the market that defines the economy, not the other way around. Because with the economy a whole maze of smoke and mirrors to begin with, and purely reliant on nothing but perception, what is one more lie to add upon all the other lies.
We point out that even if we knew which economic scenario would unfold, GDP has often been PREDICTED by the S&P500, such that the coincident correlation between the quarterly GDP and the S&P500 has averaged zero over the past several decades (Exhibit 7).