Now that a cottage industry has emerged practically overnight, with Wall Street firms rushing to offer their predictive services as to what will happen as a result of the Russia-Ukraine conflict (a conflict most of them dismissed ahead of time), and how various markets will respond to further escalation and de-escalation (such as Goldman), one bank is refreshingly honest in its admission that it doesn't really know what happens next.
In his latest Weekly Warm-Up note, Morgan Stanley chief equity strategist Michael Wilson - a/k/a Wall Street's Biggest Bear - writes that over the past few weeks, "Russia/Ukraine headlines have taken center stage for markets but our work suggests slowing growth is just as important. While we have no edge on whether Russia will invade Ukraine, a lot has been priced."
According to Wilson, "while we have no particular edge in predicting what happens next in the Russia/Ukraine situation, we're not sure anyone really does." Instead, in situations like this, he says that he look to the markets for insights, as the wisdom of crowds often has a better chance of predicting the outcome than we do. But on that score, "it's messy, too. While there has been a flight to safety in Gold and Treasuries, Brent crude has stalled out in the low 90s and shows signs of exhaustion on some technical indicators (DeMark and oscillator divergences)."
"The bottom line," according to Wislon, is that "the markets are sending mixed signals in our view."
Where Wilson is less confused, however, is that what is coming next for stocks will be ugly, and it has little to do with the geopolitical vagaries of the Ukraine crisis, and everything to do with the slowdown in the economy and the growing risk to earnings he has been warning about for months (and certainly last week in "Wall Street's Biggest Bear Warns Stocks Are About To Be Hammered By A "Polar Vortex" Of Collapsing Growth").
Of course, even Wilson admits that by this point, his "Fire and Ice" narrative which was first revealed almost a year ago, is probably tiresome to readers but nonetheless, he is still using it mainly because as he puts it, "the push back to the Ice portion has taken on a new level of resistance."
From our standpoint, that's important because it means it's not priced. As we discussed in last week's note, we think Fed tightening is well understood at this point even if it's not fully discounted in multiples.
As a result, from this point on, the depth and duration of the ongoing correction will be determined primarily by the magnitude of the slowdown in 1H 2022, Wilson writes. And while the Russia/Ukraine situation obviously could make this slowdown even worse, the preexisting fundamental risks he (and we) has been focused on for months will be the primary drivers.
And speaking of the underlying slowdown which we have been discussing for months, Wilson notes that while "most economic and earnings forecasts do reflect a slowdown from last year's torrid pace, we think there is a growing risk of a greater disappointment in both." Like us, Wilson has staked his bearish case primarily on slowing consumer demand as confidence remains low thanks to generationally high inflation in just about everything the consumer needs and wants.
Here Wilson interjects by pointing out that many investors he speaks with counter that the consumer will hold up better than the confidence surveys suggest: "After all, high frequency data like retail sales and credit card data remain robust while many consumer-facing companies continue to indicate no slowdown in demand….yet."
To this, Wilson in turn counters that most Morgan Stanley leading indicators already suggest the risk of a consumer slowdown remains higher than normal. Secondarily, and just as importantly, is the fact that supply is now rising: while this will alleviate some of the supply shortages, it could also lead to a return of price discounting for many goods where the inflationary pressures have been the greatest. That's not only a problem for margins, but it's also a risk to demand if the improved supply reveals a much greater level of double ordering than what is anticipated by companies. In short, "the order books—i.e., demand picture—may not be as "robust" as believed" according to MS.
Throw in a potential energy price shock from Ukraine - which will lead to further consumer exhaustion as even more disposable income is spent on staples such as gas and heating - and it only gets worse.
But wait, there's more, because if one looks at US equities the technical picture is even more mixed: echoing what we have said over and over, Wilson writes that "rarely have we witnessed such weak breadth and havoc under the surface when the S&P 500 is down less than 10%. In our experience, when such a divergence like this happens, it typically ends with the primary index catching down to the average stock."
In short, according to the chief US strategist, while "this correction looks incomplete" he also appreciates that equity markets are very oversold, and sentiment is bearish, even if positioning is not. Furthermore, with the Russian/Ukraine situation now weighing heavily on equity markets, "relief in the situation would likely lead to a tactical rally" but uncertainty remains extremely high around the situation.
Putting it all together, Wilson says that the current situation looks similar to late 2018, with the most apparent similarity - as we have discussed on numerous occasions being that we have an overly hawkish Fed at a time when growth is slowing. Back in September 2018, the market viewed Powell's "auto pilot" comments on rates hikes and view that policy remained far from neutral as tone deaf, particularly as credit markets were getting roiled in December. This time, the Fed is responding to record high inflation and is arguably behind the curve. So, while it's hard to argue the Fed is making a mistake by signaling such an aggressive tightening schedule, it could mean they really are on auto pilot this time and therefore may find it very difficult to pivot back.
In other words, Wilson says that "the odds are increasing we end up with a similar outcome as December 2018" when stocks tumbled as much as 20% from their recent highs before staging a sharp rebound as the Fed capitulated.
And to visualize Wilson's assessment, the chart below shows a price analog versus 4Q 2018 that's holding up well. If we were to get some signs of a de-escalation in Russia/Ukraine tensions, it seems like a quick 5% rally is not out of the question. However, uncertainty is high here, and this would simply work off the oversold condition. Here Wilson caveats that his experience with analogs is that they eventually break down as the past is never a perfect prologue but "nevertheless, it's worth watching until it does."
Wilson's bottom line is that while he really doesn't have a strong view on the Russia/Ukraine situation (even if he thinks a lot of bad news is priced at this point), and signs of de-escalation could lead to a relief rally in the near term given the lack of hard evidence for his "Ice" thesis, the risk of tensions escalating is elevated and come March, "the Fed will actually begin to tighten policy as opposed to just talking about it." This will come just as the data begins to roll over with respect to growth, or more specifically, "decelerating earnings revisions and more acknowledgements from companies that demand may be slower than anticipated as supply comes on line and costs remain an issue."
There is more in the full Michael Wilson note, available to pro subs in the usual place.