Yesterday, we reported that in Morgan Stanley's Sunday Start note, the bank's chief US equity strategist, Michael Wilson, wrote that while valuations have corrected a lot this year, this was all due to higher inflation and a more hawkish Fed. At the same time, the Equity Risk Premium (ERP) still does not reflect the risks to growth which are increasing due to margin pressure and weaker demand as the consumer decides to hunker down.
The reason for this is that in contrast to rates, the ERP is a reflection of growth expectations. When growth is accelerating/ decelerating, the ERP tends to be lower/higher; at year end, the ERP was 315bps, well below the average of the past 15 years. It was also below our estimate for the ERP of 335bps at the time. In short, the ERP was not reflecting the rising risks to growth in 2022 that Wilson expected coming into this year. Fast forward to today, and the ERP is even lower at just 295bps. Given the rising risk of slowing growth and earnings, "this part of the P/E seems more mis-priced today than 6 months ago" according to the MS strategist.
So given the further deterioration in leading growth signals and greater risk of recession (as Wilson discusses further in his observations on consumer confidence, see below), one could - or should, according to Wilson - argue the ERP should be at least 500bps until earnings are cut. Of course, a recession would also bring lower 10-year yields which would buffer some of the rise in the ERP.
Bottom line, according to Morgan Stanley, the final answer depends on all three variables:
- 10-year yields (lower),
- ERP (higher)
- forward 12-month EPS forecasts (lower).
As such, if the US avoids a recession over the next 12 months (which is still Morgan Stanley's base case), Wilson sticks to his Street-low view of 3,400 for the S&P 500 is "a more reliable level of support" that takes into account:
- The view for 3-5% lower earnings than consensus forecasts,
- A 3% 10-year yield, and
- An ERP of 370bps.
This all translates to approximately 15x $230 in EPS. It's also where Wilson sees technical support for stocks: the 200 week moving average, the pre COVID highs and the break out point from the announcement of the vaccines
Of course, if we do have a recession, all bets are off and even Goldman is openly cautioning that 3,150 on the S&P may be as good as it gets...
... in line with what the bank disclosed in its recently published "recession manual."
So much for markets, which today are clearly taking Wilson's warning to heart and at 3,750 are already almost half way to his 3,400 target, after trading at 4,100 just last Thursday.
What about the economy?
Here things are even uglier, because when it comes to the consumer, the debate "should be over now" according to Wilson, who echoes what we have been saying for months, and especially after every time we show the monthly explosion in credit card usage. But one doesn't even have to look at credit card usage: consumer sentiment - or lack thereof - will suffice.
According to Wilson, consumer sentiment in the US hit an all-time low in May due to higher prices and growing concerns inflation is here to stay. This is an argument both Wilson and we have been making since late last year. But while we can write whatever we want, Wilson complains that he continually hears from many clients that the consumer is in such great shape due to the excess savings still available in checking accounts, something we have shown repeatedly is a glaring lie.
And indeed, this view does not take into account savings in stocks, bonds, crypto and other assets which have been hammered this year. Furthermore, while many consumers may have more cash on hand than pre-COVID, that cash just isn't going as far as it used to - thank Bidenflation - and that is likely to restrain discretionary spending by the consumer. Finally, it's important to point out that this latest reading is the lowest on record and 45% lower than during the last time the Fed embarked on such an aggressive tightening campaign and was able to orchestrate a soft landing. In other words, Wilson notes, "the consumer was in much better shape back then which probably helped the Fed land the plan softly"; he also urges readers to also keep in mind that "inflation was dormant in 1994 relative to today and allowed the Fed to pause, a luxury they clearly do not have now given Friday's red hot CPI release."
Interestingly, the collapse in consumer sentiment has also been present among higher end households, indicating the pervasive reach of rising inflation.
As the next chart shows, goods purchasing intentions continue to plummet alongside the fall in overall household confidence (even if actual retail spending remains strong, suggesting consumer confidence surveys aren't really worth the inflated paper they are printed on). Wilson warns that this dynamic has negative implications for goods consumption as the exhibit shows: "The drop in sentiment not only poses a risk to the economy and market from a demand standpoint, but it also, coupled with Friday's CPI print, keeps the Fed on a hawkish path to fight inflation—"Fire" AND "Ice"."
Shifting away from the recessionary state of the consumer, Wilson next pivots to commentary from Morgan Stanley analysts during the latest monthly meeting which focused around inventory and the health of the consumer. As Wilson explains, "everyone agreed the low income consumer is already facing challenges." This lines up with the latest results from the bank's Alphawise Consumer Pulse Survey which shows consumers are particularly concerned about inflation, and they are expecting to reduce spending over the next 6 months as a result of high prices. Analysts across different industries also commented that supply chains are loosening and inventory is building: "This build is currently most challenging for retailers, but we expect this to broaden out over the coming months."
Summarizing The next shoe to drop is a discounting cycle—a key risk to margins, particularly for Consumer Discretionary goods. In other words, precisely what we said in "Bullwhip Effect Ends With A Bang: Why Prices Are About To Fall Off A Cliff."
Below are the key highlights from various Morgan Stanley analysts:
On Technology, Media, & Telecom Companies
- For Telecom companies, there has been a slight uptick in low income consumer churn but nothing too out of the ordinary. Store traffic still looks good. People are braced that there could be some softness. The team is getting investor questions on enterprise spending but the data centers are still doing well from a demand perspective (could be related to supply chain with people trying to lock in space).
- Semiconductor inventories are rising across the board and we are getting more supply. There are still idiosyncratic shortages all over the place. You have seen demand weakness in PCs/phones but we are still not past the shortages. If we don’t have any more disruptions supply should be better in 3 months. Prices are rising meaningfully. China’s Covid zero policy has been disruptive but it has disrupted both the supply and demand sides.
- Apple is the only Tech Hardware company to noticeably bring down balance sheet inventory. A handful of covered companies still have elevated levels of finished goods inventory (some of which is in transit) but you are also seeing a build of components in case there are shortages in the future. Component and labor cost inflation (as well as FX) is pressuring margins for the majority of coverage YTD. From an estimate cut perspective, you have seen more cuts on the enterprise side versus the consumer side but there have been more negative data points around the consumer side. Most of the demand pull forward around the pandemic is thought to be consumer driven but MS checks show enterprise hardware demand has also been pulled forward, to a degree, to get ahead of long lead times and avoid potential shortages in the future.
- Enterprise software demand has remained solid. We have seen some revisions but that is largely from taking out the 1-2% of business that comes from Russia/Ukraine and adjusting for FX. Larger enterprise demand has held up. The more strategic the project the more likely growth is sustained. We are hearing about more layoffs taking place among VC funded software companies. There is a message going out from VCs to companies that they need to get on a faster track to being profitable. The expected compensation rate for engineers and sales people is likely to come down. The inflationary part of compensation has been coming from the stock component of compensation. MSFT upped the level of cash raises in response to an employee survey. They are also upping the highest level of targeted performance payout. Mid-sized companies are trying to up compensation for key performers but they are not planning to make everyone whole in response to their stocks falling.
On Consumer Companies:
- Free money is going down but spending is still high so people are borrowing money to fill the gap. The high end consumer isn’t feeling the effects as much but the low end is getting squeezed. Delinquencies for subprime auto ABS are above pre-Covid levels for consumers with a FICO score of 550 and below - that is deep subprime. Regular subprime and above is showing no signs of stress and we would need a big labor cycle to get that. Delinquencies today are losses 6 months from now but they are coming in lower than we are baking in.
- Within hardlines/broadlines/food retail most companies are making sales; they are not beating but they are at least making sales. There have been some trade downs. Home furnishings and electronics have seen some weakness. Gas prices could be the catalyst to really disrupt demand.
- Generally consumables have been holding up well and WMT/TGT have said that publicly. The experience (away from home) side of the business is still strong, with beauty and away from home beverage demand recovering as consumers are returning more to normal summer behavior. Private label has picked up a bit which shows signs of low income consumer stress and there have been modest signs of trade down so far. Cost pressures continue to be severe.
- There is a lot of low end exposure in restaurants and we are seeing some modest cracks. MCD and WEN have talked about a negative mix shift (ordering more value menu items). There is very little discounting in the space right now.
- YTD we are seeing some nice bounce back in retail in-store traffic but ecommerce has softened a bit. Store volumes for most retailers are running 10-20% below 2019 levels so we are not seeing a full in-store recovery but it is improving. The big story here is that sales growth was at the low end of plan in 1Q and we are seeing signs of stress for retailers that cater to low income consumers. We could see a soft patch of retail revenue growth over the next few quarters as sales comparisons become more challenging in 2Q & 3Q. Inventory has really backed up; inventory across the sector is up about 30% YOY and sales growth is up about 0% YOY translating to approximately 30% YOY of excess inventory. Markdown/margin pressure did not hit in 1Q and should hit June/July. Store checks show that aggressive discounting has already started as of the Memorial Day holiday weekend. Discounting pressure could accelerate through July. Since more retailers are now discounting, companies are having to offer even bigger discounts to compel consumers to buy, and it is a race to the bottom in margins in order to clear through inventory (see Gap (GPS), Urban Outfitters (URBN), & American Eagle. It will be some time before retailers can cut back on forward inventory orders. Companies are no longer in a position to order 6 months in advance because of delays in the supply chain. They are currently working with about an 8 month lead time. This means decisions today to cut forward orders could begin to eliminate the inventory problem in 1Q23, but not likely before then. As a result, we are likely to see a tidal wave of discounts that carry us through December because 2022 inventory orders have already been placed.
Bottom line: While the margin pressure and waning low end consumer demand dynamics have been largely understood by the market, Wilson is worried that the excess inventory element (largely in consumer goods up to this point) which we described here, and the associated risk to pricing is less understood and is just now beginning to be reflected in stock prices. This has been a growing risk for the past several months as the economic data has reflected this development; it's also a key reason why Morgan Stanley remained Underweight the consumer discretionary sector despite already meaningful underperformance this year. Exhibit 8 shows that real (i.e., this is not just price related) inventory levels for durable goods + apparel are now well above trend after surging in recent months. Wilson attributes much of this to the likely loosening of supply chains that took place in 1Q.
There is more in the full Morgan Stanley note available to pro subscribers in the usual place.