Authored by Andrew Sheets, chief global strategist at Morgan Stanley
For all the sound and fury of the last month, global stock markets are roughly unchanged. Our overall strategic stance remains constructive, on the view that an improving trend in economic data will matter more than a poor level, risk premiums generally remain above average, policy support is aggressive and sentiment is reasonably cautious. We continue to think that the best way to express this positive view is buying corporate and securitized credit, selling equity and credit volatility and overwriting equity and credit indices.
Yet unchanged markets belie a host of uncertainties and the continuing stream of unprecedented developments. With much in flux, our focus today is on two "good" events that we think could actually be problematic, and two "bad" events that we’re more relaxed about.
Repeat something often enough and it will start to sound true. There’s an element of this in the idea that ‘lower interest rates are a positive for markets and the economy’, a notion that’s both a regular feature in financial commentary and hard-wired into many measures of financial conditions. Without belabouring the point, while lower rates are a good thing for demand and valuation all else equal, ‘all else equal’ is frequently not the case when yields are moving.
Which brings us to our first ‘good’ thing – negative interest rates: After April saw oil trade at a negative price, this week brought markets pricing negative short-term rates in the US and UK. A number of reasons could explain this, from record unemployment, to investor positioning, to comments by the US president. Yet while it’s tempting to see even lower rates as a potential positive, we would not.
Their track record, quite simply, is poor and provides plenty of circumstantial evidence that their damage to confidence and financial stability far outweighs the benefits. Since the eurozone and Japan implemented negative rates in June 2014 and January 2016, respectively, both regions have seen greater underperformance of their stock markets, economic growth, loan growth and bank valuations than the US (which kept rates positive). We think that the Fed’s long-standing reluctance to take rates negative is well founded, and our economists and interest rate strategists expect it to hold this line.
The second ‘good’ thing we’re worried about is a faster ‘reopening’ of the economy: Two weeks ago, market strength was attributed to the hope that many economies would see a faster easing of restrictions. But we think that this is backwards. Markets have historically been very forgiving of slow recoveries and extremely weak data, as long as they’re set to improve. But markets have low tolerance for losing that positive rate of change, which conjures up all sorts of terrible scenarios. We think that some of the weakness this week reflects increasing market concerns about that sort of relapse, especially in the US.
In turn, while we frequently hear that the market isn’t prepared for a slow, ‘U-shaped’ recovery, we would be more relaxed: After all, a ‘U’ implies that the worst is behind us, and the rate of change is positive. History suggests that markets routinely look ahead. And for all the talk that ‘the market is expecting a V-shaped recovery’, this is really not the impression we get from discussions with investors or from the leadership within the market. We think that actual economic expectations are pretty modest, as reflected in the low level of interest rates, the valuation discount of cyclicals and very high investor cash balances.
If a U-shaped recovery is one ‘bad’ development we’re actually more relaxed about, inflation is the second: For obvious reasons, there’s broad agreement among investors and economists that 2020 will see powerful deflationary forces unleashed by a collapse in demand. But opinions are divided about what comes after. My colleague Chetan Ahya and our global economics team believe that 2021-22 is more likely to see inflation than disinflation, as a gradual recovery in demand, aggressive policy action and continued de-globalisation all help to normalise price levels.
Is this a problem for markets? We don’t think so. The inflation we’re forecasting results directly from expectations of better economic growth in 2021 and 2022, and thus only occurs in a scenario where the underlying economy is in better shape.
We think that central banks will continue to err on the side of caution and provide significant accommodation into 2021, even if inflation starts to pick up. And our work suggests that the best forward returns for equities and credit occur when inflation is materially below trend (as it is today). Inflation overshoots do not bode well for forward returns, but such an outcome is still a long way off.