By Michael Wilson, chief US equity strategist at Morgan Stanley
Growing up in the Midwest in the 1970s, I remember much colder and snowier winters that started earlier and lasted seemingly forever. With global warming, the winters are milder, start later and end earlier. However, one thing has not changed – winter always comes. This year has been no different despite a late start; the thermometer outside my window currently says minus 10 degrees Farenheit!
In the markets, investors have become fixated on the Fed’s every move. That makes sense with the Fed pivoting so aggressively on policy over the past few months. It also fits nicely with the first part of our well-established 'fire and ice' narrative and our view that equity valuations are vulnerable. The reason for the Fed’s sharp pivot is obvious as inflation has overshot its goals, leading to problems for the real economy and the White House. When the Fed first announced its inflation-targeting policy in summer 2020, it was appropriate given the deflationary effects of the pandemic. Therefore, it’s now just as appropriate for the Fed to tighten at an accelerated pace to fight the inflation overshoot. This is a big change for a Fed that has been fighting the risk of deflation for 20+ years.
Importantly, consumers are truly starting to feel the impact of inflation, with the University of Michigan confidence survey currently at levels typically observed only in recessions. Small businesses are also feeling the pain, as demonstrated by their difficulty finding employees and the prices they are paying for supply and logistics. These problems have been reflected in small cap stocks’ dramatic underperformance over the past 10 months. In short, the Fed is serious about fighting inflation, and it’s unlikely that it will be turning dovish any time soon given the seriousness of these economic threats and the political cover to take action [ZH: we disagree].
The good news is that markets have been digesting this tightening for months. Despite the fact that the major US large cap equity indices are down only 5-10% from their highs, the damage under the surface has been enormous and even catastrophic for many individual stocks. Expensive, unprofitable names – i.e., the most speculative parts of the equity market – have been hit the hardest, down 30-50%. This is appropriate in our view, not just because the Fed is pivoting but because these kinds of valuations don’t make sense in any investment environment. In short, the froth is coming out of an equity market that simply got too extended on valuation.
But attention should now turn to the ice part of our narrative – slowing growth. As we’ve been writing for months, we view the current deceleration in growth as more about the natural ebbing of the cycle than the latest variant of Covid. Indeed, there are reasons to be optimistic that Omicron will prove to be the final wave of this pandemic. However, that also means the end of extraordinary stimulus, both monetary and fiscal. It also means looser supply chains as restrictions ease and people fully return to work. Better supply is good for fighting inflation but may also reveal the degree to which demand has been supported and overstated by double ordering. Weaker PMIs are already leading stocks in this regard (Exhibit 1).
This would fit nicely with the 1940s analogy that we detailed in our outlook and our This Cycle Could Run Hotter but Shorter note almost a year ago. In brief, the end of World War II freed pent-up savings and unleashed demand into an economy unable to supply it. Double-digit inflation ensued, which led to the first Fed rate hike in over a decade and the beginning of the end of financial repression. Sounds familiar? Shortly thereafter, inflation plummeted as demand normalized, but the Fed never returned to the zero bound. Instead, we began a new era of shorter booms and busts as the world adjusted to the higher levels of demand as well as cost of capital and labor. The end of secular stagnation and financial repression has arrived, but it won’t be a smooth ride.
In the near term, hunker down for a few more months of winter as slowing growth overtakes the Fed as the primary concern. In such a world, we continue to favor value over growth but with a defensive rather than cyclical bias – i.e., hibernate until winter is over.