Morgan Stanley On Why The Gig Is Up
"What we have on our hands is a good old fashioned quagmire" is how Morgan Stanley's Mike Wilson sets up his surprisingly non-sheep-like perspective on the troubles that US equity investors may be about to face. Expanding on MS's bearish strategic (fundamental) forecast, that we discussed earlier in the week, Wilson combines the 'liquidity vs negative-real-rate' thesis (that the Fed's liquidity is perhaps no longer 'good' for stocks) with his own views on ECRI's weakness (very 2008-like in relation to ECO surprises), household debt deleveraging (more and longer), how much QE3 is already priced in and what will its effect be when it comes (less and less positive in nominal and real terms), investor sentiment (very bullish), long-term technicals (weak breadth), and short-term earnings expectations (deteriorating and weighted to 'weak' financials to end with the pragmatic realist perspective that perhaps 'the gig is up'.
MS notes both tail-winds falling and expectations rising as a possible double-whammy for stocks:
Vincent Reinhart reminds us that recent growth has been lifted by 2 temporary tailwinds. Namely, the unwind of the negative shocks from Japan’s earthquake and the run-up in energy prices early in 2010. Furthermore, we are currently in the anniversary period of the 2% payroll tax cut from last year. This will have a drag on y/y growth as well.
For those that are still not convinced US GDP growth is vulnerable, check out Exhibit 3. Even with the better high frequency data on the economy (Economic Surprise Index), it has not been enough to change the trajectory of the outlook for growth (ECRI LEI). If anything, there has been a further deterioration in this very reliable economic leading indicator. Keep in mind that the stock market is one of the key components in the ECRI and equities have recovered sharply. This suggests the economic variables are even weaker than the headline index. Finally, this is very similar to what we saw in 2008 and much different to the temporary slow down in 2010.
The Fed and QE3 Expectations
While today's NFP print may be good for Obama's talking points, MS notes that the Fed may still reduce growth expectations as their 'prompt' for QE3 and even so, the market seems to have priced this in to a significant level already:
Consistent with Vincent’s projection for a significant GDP slowdown in 1Q, he believes we are likely to see a meaningful reduction in the FOMC member forecasts over the next several meetings. Vincent proposes this reduced forecast will give the Fed the ammunition they need to justify QE3 sometime in the spring. Why are they doing this? I think it’s pretty clear our “recovery” remains tepid at best and shaky at worst. The Fed is simply taking out a little insurance against another growth scare that appears likely to begin in 1Q and get progressively worse throughout 2012. They also know this is an election year and that implementing QE3 could create a political firecracker. Therefore, if they are going to act, they had better act early and definitively. I think Vincent is onto something here and I would expect the Fed to signal QE3 perhaps as early as their next meeting.
Based on Vincent’s reading of the Tea Leaves, they are preparing to make their case to the public. The rhetoric is likely to only get louder as the economic data gets weaker.
So we are left in the purgatory of slowing economic growth + QE3. I feel like Bill Murray in the movie Groundhog Day, losing the will to wake up each morning to live the same day over and over again. We all know how the day ends and it’s just not as fun the 3rd time around. In fact, I could make the case that QE3’s impact is likely to be even smaller than QE2. QE1 kept stocks elevated for about a year and resulted in approximately 600 SPX points (666 to 1225). Meanwhile QE2 was only able to keep markets propped up for about 6 months and gave us 300 SPX points (1050 to 1350).
So what should we expect from QE3? 3 months and 150 SPX points? And, what if we already got it? After all, stocks bottomed in early October at 1100 and here we are 3 months later at around 1250. Maybe the market has already discounted the Fed’s next act much like it did with QE2. Finally, I think it’s important to point out that the world’s central banks have been printing wildly for the past 6 months and gold is breaking down. This suggests to me they are behind the curve and not printing fast enough and so QE3 may only keep us running in place at best.
Fed Liquidity Losing Luster
Even with QE3, the MS sales-trader suspects the gig is up as liquidity's impact is marginal and historically speaking whether inflation or deflation is around the corner, equities will struggle:
QE3 and incremental fiscal stimulus could help stocks grind higher in the near term, but if companies continue to miss numbers at the same pace we have observed in the early CY4Q reports, stocks are going lower. Furthermore, it’s not clear to me if additional liquidity is going to be good for stocks at this point. History suggests that once real interest rates actually go negative, it’s no longer good for stocks. Adam’s 2012 outlook note presents a hypothetical chart of what the equity risk premium looks like at different risk free rates (Exhibit 5).
Rather than a nice linear relationship between the 2 variables as the Fed would like to believe, it is more of a “smile” that suggests equity risk premiums actually rise as we approach zero risk free rates. After all, the reason risk free rates are zero is because things are so screwed up! Similarly, as rates rise too much, the equity risk premium rises at a non-linear rate. I think this is an eloquent way of saying monetary policy has simply run its course.
I decided to take Adam’s theory a step further and look at how many times in history we have had negative 10-year real interest rates since the Fed’s charter was first created in 1913. It hasn’t been often. Please look at Exhibit 6 and notice the periods in which we had negative real rates. The dates are 1915-20; mid 1930s, 1940s, 1970s and today. While hardly scientific, it doesn’t take a financial markets historian to know these were not stellar times to be invested in equities.
What is interesting to me is that these periods incorporate times of both deflation (mid 1930s) and inflation (WWI, WWII and 1970s). In other words, maybe it doesn’t matter if the gold bulls (inflationists) or the libertarians (deflationists) are right. In either scenario, equities are likely to struggle, and the gig may finally be up.
Long-Term Chart Worries
Exhibit 8 shows that the SPX has closed above its 200-day moving average for 3 consecutive days to start the new year, a clear positive. However, it is struggling to break through the former neckline from the well established head and shoulders pattern in 2011. It is also in the process of forming the right shoulder of a much larger and ominous H&S pattern.
The neckline for this H&S comes in around 1100 and counts all the way down to 775 if it breaks. Yikes! At the end of the day, I think this chart sums it up pretty well. The neckline and 200 day moving average represent the upper bounds of where this market should trade on a fundamental basis. I think we are towards the upper bound today due to the significant monetary stimulus currently being provided by several central banks and on the assumption that the Fed is not far behind. As 4Q earnings season begins, I suspect we will fall from current levels and possibly test the neckline of the larger H&S pattern. If the earnings picture materially worsens in 1Q and 2Q, this neckline could break.