Excerpted from the latest Morgan Stanley Sunday Start note authored by Andrew Sheets, Chief Cross-Asset Strategist; full note available to professional subs.
Better Late than Never
In a world filled with so much tragedy, any good news is welcome. And so it was this week as London saw the opening of the Elizabeth line, a new railway that tunnels from one end of this great city to the other. It’s been the largest infrastructure project in Europe, a marvel of modern engineering and a testament to the fact that great, big things are still possible.
It was also several years overdue. This big, transformative project required more than a bit of patience. But the end result will be a better, more sustainable system.
This idea of 'better late than never' also rings true for markets.
The post-GFC period was filled with paradoxes. It was a period of serially disappointing economic growth but exceptional cross-asset returns. Wealth exploded in relation to the economy, while capital investment withered. It was a period of fragility that demanded enormous policy support, yet produced a remarkably consistent pattern of performance. From the January 1, 2010 trough to the end of last year:
- US equities outperformed RoW in 10 of 12 years;
- Growth outperformed Value in 9 of 12 years;
- Bonds (US Agg) outperformed cash in 9 of 12 years;
- Global equities outperformed commodities in 9 of 12 years;
- The fed funds rate averaged 0.67%.
That consistency in performance often mirrored consistency in the macro economy. Generally speaking, 2010-21 saw low inflation (US core PCE averaged 1.8%Y), low growth (US GDP averaged 2.0%Y) and central bank policy that was both supportive and predictable, with investor faith in a central bank 'put'.
All this is changing. Year to date, commodities have outperformed stocks, cash has outperformed bonds, Value has outperformed Growth and non-US stocks are beating their US counterparts (especially if you hedged the currency). The macro backdrop is also different; US core PCE just printed at 4.9%, US 1Q nominal GDP was +10.6% YoY and capital investment is strong, while global central bank policy has been more restrictive, less predictable and has thrown cold water on the idea of a policy solution to every market wobble.
Does this shift have risks? Yes. But how many conferences did you attend in the last decade that bemoaned the trapped state of the global economy, doomed to a future of insufficient demand that required extreme monetary policy as far as the eye could see. As recently as December, German 30-year bond yields were -0.07%. Today, the ECB policy rate is expected to be ~1.0% in 12 months. In a choice between those two economic futures, give us the latter.
Trends below the surface also point to encouraging change. Any bear market leads to the question of whether to ‘abandon the process’, because rational analysis can be overwhelmed by questions like: 'will the financial system survive' (2008-09), 'will the European Union survive' (2011-12), 'will the VIX create forced sellers' (2018) or 'can we handle a global pandemic' (2020).
But this is not one of those trauma-induced bear markets. Year to date, relative value has been working, especially when it comes to cross-asset factors (see Cross-Asset Spotlight: Systematic Strategies (CAST): RV Rules, May 27, 2022). And price action has often been about (finally) normalizing some extreme valuations. Not sure how a particular asset has done so far this year? 'Moved closer to its average valuation over the last 20 years' is a pretty good guess.
'Better late than never' also feels appropriate for the central bank debate. It’s easy to argue that policy remained too accommodative for too long. But hindsight is cheap and easy; what matters now is that policy is normalizing, in a significant way. More importantly, this shift has credibility. The US, eurozone and Australia are priced for terminal rates that assume the economy can handle further tightening. Inflation expectations are now falling, the housing market is cooling and credit risk premiums are back near the long-run average. If this is a ‘policy error’, more than a few central bankers must be thinking, 'that’s fine by us!'
What does all this mean for the markets? We think we’re through the worst of markets being surprised by inflation and policy. That should help yields to stabilize over the summer and bring down rate volatility, which in turn should help mortgages, munis and IG credit (in that order). We think it’s too soon to buy HY, especially after this week’s pop, but expect outperformance of CDS over cash as investors decide they are well hedged for the current uncertainty (see Cross-Asset Playbook: Organized Chaos, May 20, 2022).
Finally, energy over metals remains a good example of relative value that can continue to work. Energy commodities generally have better carry, better momentum and more fundamental support (tighter markets). The ratio of 12-month Brent crude to gold has risen, but it is still 30% lower than it was 20 years ago. Better late than never.
All reports mentioned in this note available to pro subs in the usual place.