It's a Monday, which means Morgan Stanley's bearish equity strategist, Micheal Wilson, is out with a fresh dose of optimism-crushing ruminations on last week's key catalyst that sent stocks soaring. That, of course, was the "Phase 1" trade deal with China that was announced by the Trump administration (if not China), and on which Wilson promptly pours cold water, saying "it will probably come as little surprise to readers that we were underwhelmed" by what was announced.
First, Wilson adds to the heap of criticism that was previously discussed over the weekend, saying that for him, "the bottom line is that without a significant roll-back of existing tariffs, we don't see how a "mini-deal" will change the currently negative trajectory of growth in both the economy and earnings." In fact, he reiterates his long-held view that the threat of a deal has been keeping fundamental investors from selling for fear of missing out on a trade deal rally."
Next, the Morgan Stanley strategist compares the price action from last week's announcement, one which "elicited an extreme two-day rally in global stocks and sell-off in rates" coupled with "a noticeable shift in leadership toward the more cyclical parts of the equity market" to the "ceasefire" reached on December 1, 2018, and which after an initial burst of euphoria then promptly fell apart resulting in a sharp plunge in risk assets. As Wilson writes, "Friday's price action was strikingly similar to what we experienced the last time we had a trade truce on December 1, 2018, at the G-20 meeting in Argentina. The next trading day on December 3 saw a big gap open that faded into the close. What followed next can be seen in Exhibit 10."
As the bank strategist continues, while we "heard a lot of optimism around this so-called deal, we heard similar things the last time. We argued then, much like we are suggesting today, that such a pause in further tariffs might actually lead to a fall-off in activity in the global economy given elevated inventories and ongoing margin pressure."
For now, the market is ignoring the similarity between October 2019 and December 2018, even though as Wilson adds, most of his conversations with clients on Friday were around whether this new leadership could persist—a concern for many of whom are not positioned for such a rotation. Indeed, as we pointed out on Friday, the rotation below the surface ended up hurting most active managers as many were not positioned for the kind of unwind that took place. Wilson explains further:
Although equity markets rallied sharply on Friday, it was the kind of rally that actually hurt the relative performance of most equity portfolios, both active and passive. It is the ultimate pain trade in an up market. To put the move in context, MSCI All Country World Index was up 1.37% while the vaunted and over-owned S&P 500 was up only 1.09%. Drilling down to the US more specifically, long momentum stocks in the US underperformed short momentum stocks by 2.68%, reminiscent of what we witnessed during the momentum breakdown in September. If such a pattern persists, it could be quite painful to many active and passive equity strategies, which ultimately will weigh on risk taking, in our view.
Ah, the irony: a surging stock market, and most professional investors getting steamrolled. Alas, if Wilson is correct, the pain will only grow from here, and not so much because the bank strategist thinks a trade truce is not an incremental positive, he just doesn't think "trade has been the primary driver of the slowdown experienced over the past year, as many others seem to believe." Instead, Morgan Stanley is sticking with its original thesis from over 18 months: that the fiscal stimulus in the US would lead to a classic boom/bust cycle that must now complete itself. To recall, the fiscal stimulus was enacted at a time when the US economy was finally reaching escape velocity, we were at full employment and companies were beginning to invest in a healthy manner. The tax cuts then created excesses that would ultimately need to be wrung out.
Wilson then list the three core catalysts that have been behind the global economic slowdown, and which have little to do with Friday's announcement, starting with...
1. Capex: "Most people assume capex has slowed this year because of trade uncertainty but our view has always been that capex would disappoint this year because companies overspent last year with their windfall profits and overseas cash repatriation." To prove his point that capex is right on schedule with Wilson's view, he notes that capex has tracked earnings growth very closely over the past 20 years and appears to be doing that again as our earnings recession call plays out.
2. Inventories: "When economic activity heats up above trend, companies tend to over order for fear of not having enough product on hand. There is nothing worse than to make a sale and not have the product to deliver. Given how fast the US economy accelerated last year, there is little doubt we saw double ordering of many items, which of course ended up in inventory when demand slowed from the stimulus-induced levels." Based on the latest wholesale inventory and sales data from this past week, Wilson claims that "we are far from completing this inventory cycle by looking at the spread between sales and inventory growth." Indeed, the red bars shown below suggest we are still many months away from where we were in 1Q2016, the last time we had an inventory correction of this magnitude and when markets bottomed. Looking ahead, the strategist expects order rates to remain below sales levels for 3-6 more months given wholesaler sales growth is already at zero. Meanwhile, as a result of the trade war, some companies have been inspire to hold more inventory than normal due to the risk that tariffs may be increased further. Ironically, "a trade deal may actually reduce the desire to hold more inventory now that this risk has diminished" Wilson cautions, and warns clients to look for an acceleration in order cancellations in many areas that are either on the tariff list or were about to be tariffed in December. One area that is especially vulnerable is semiconductors, where inventories are at all-time highs across the industry.
3. Labor. "Companies have been reducing capex and opex and have also been trying to reduce labor costs via few hours worked and wage growth, which is now decelerating sharply" (charts below). While until now, companies had not reduced headcount, some of which is due to the fact that firing and re-hiring employees is expensive, forcing CFOs to put this off as long as possible, "hope for a trade deal may have also been holding back some of these decisions." With the trade deal now announced and additional tariffs postponed, if business does not pick up, there may be less apprehension to make the harder decision on head count, according to the ever "cheerful" Wilson. Indeed, citing the bank's industry analysts, Wilson notes that they expect 'restructuring' announcements to become more prevalent during the fourth quarter as companies decide to flush this year's results in hopes of saving next year's.
Several other leading indicators on labor also suggest we are closer to this decision than "meets the eye."
To Wilson, the bottom line is that growing trade tensions between the US and China were used as an excuse by companies and investors for the disappointing growth experienced this year. As a result, too little attention has been paid to the force of the ongoing business cycle downturn that Morgan Stanley saw as inevitable after the fiscally induced boom last year, and which set the table for the eventual end of the cycle. Given the unpredictable path of these trade tensions, they have also been used as a reason by many companies to hold onto employees longer than they normally would for fear of missing out on the potential boomerang rebound from a substantial trade deal. Unfortunately, as Wilson pours yet another gallon of salt on the festering wound, "the preliminary agreement announced on Friday will fail to lead to the kind of rebound necessary to change the slowing growth trajectory we have been experiencing all year."
It's not all gloom: Wilson admits that unlike 2018, there is a distinct positive offset in that this time central banks are
loosening policy, but even this he argues is countered by the fact that we are further along in the earnings recession and next year, companies may only have one lever left to pull to save margins : slashing head count.
What does all this mean for markets? It is here that Wilson's gloom shines - so to speak - through all the fading optimism, as the strategist now expects "Friday to mark the near-term highs and the next few weeks/month to resemble what we saw last December albeit less dramatic given the lower interest rates and easier monetary policy that now prevails."