"Are You Ready For Greed?" Morgan Stanley Asks

“And some things that should not have been forgotten, were lost” - The Lord of the Rings

 

"Are you ready for greed?" asks Morgan Stanley's Andrew Sheets in his Sunday Start note, in which he compares the current market situation to the early days of 2007, when the first harbingers of the financial crisis emerged (recall "10 Years Ago Today, The Financial Crisis Started With An Announcement By HSBC") and when early warnings that it would all end in tears were roundly ignored for almost a year, all because of - you guessed it - a resurgence of greed.

"It’s happened before. As TABX cratered and credit markets wavered in early 2007, the S&P 500 went on to make new highs, not peaking until October. Greed is a powerful force. We are trying not to forget that."

Morgan Stanley notes that after the crisis, greed became an anachronism as animal spirits died along with a wholesale shift in investor mentality:

Caution became unusually acceptable, whether due to real concern or survivorship bias. Corporates slowed investment, pushing capex well below trend. Investors pulled money out of stocks, despite a rising market. Banks cut balance sheets and reduced staff. Implied volatility remained unusually elevated over realised. Conferences became filled with speakers talking about just how bad the financial future might be.

 

There was almost an ‘end of history’ feel to it: That banking and the economy have fundamentally changed. That we’ve learned from our errors. That animal spirits won’t be allowed to return. This mindset has had pros and cons: It’s starved investment under the auspices of ‘financial prudence’, a somewhat self-fulfilling prophecy which meant low growth encouraged low growth. But it also led to a more stable financial sector, the seventh-longest US expansion in history, and global equities flirting with all-time highs. That’s a debate for another Sunday.

According to the bank, however, this may be changing. At least it hopes it is:

What matters now is if this mindset changes. The passage of time, coupled with the signals of the new US administration, is raising the odds of increased aggressiveness. The return of fully fledged ‘greed’ is not our base case. But it is a serious enough possibility to weigh on our thinking and our recommendations. Further steps towards it are one of several factors that we think support a 1Q ‘sparkle’.

Here's why MS is hopeful:

Consumer confidence is the highest since 2001. Business confidence is the highest since 2004. US unemployment is 4.8%. G4 central banks continue to run exceptionally easy policy. Fiscal policy is already loosening in Japan and Europe, and is expected to loosen (significantly) in the US. It is quite a cocktail – easy credit, easy fiscal and monetary policy, high confidence and a self-professed ‘business-friendly’ US administration. Asset valuations certainly aren’t cheap. But then again, how often do greedy markets care about valuations?

So is the message here to throw caution to the wind, and just buy everything with both hands hoping others will be even greedier and allowing an easy way to offload exposure, or that with the VIX at levels that were last encountered in early 2007, and complacency pervasive, what comes next will be unpleasant?

Here is the full note from Sheets, so readers can decide for themselves (highlights ours).

Are You Ready for Greed?

 

10 years ago, almost to the day, trading launched something called TABX. A close relative of the ABX subprime indices, it aimed to provide a transparent way to both buy and sell risk on subprime-backed CDOs. But what was meant to be a tool to provide market liquidity and better risk management had the opposite effect. Prices on TABX collapsed, as investors finally had a way to express what they thought bonds were worth. Parts of the index meant to mimic AAA-rated bonds paying 0.50% per year lost 20% within hours. Now confined to financial infamy, TABX did provide transparency for subprime: An AAA-rated bond, in theory, should lose about 3bp/year. TABX suggested the losses on ‘AAA’ ABS CDOs could be 1000x that.

 

Such severe miscalculations shaped the crisis and the decade to come. 2008-09 didn’t just batter the economy, or the markets, or faith in institutions. It changed mindsets.

 

Caution became unusually acceptable, whether due to real concern or survivorship bias. Corporates slowed investment, pushing capex well below trend. Investors pulled money out of stocks, despite a rising market. Banks cut balance sheets and reduced staff. Implied volatility remained unusually elevated over realised. Conferences became filled with speakers talking about just how bad the financial future might be.

 

There was almost an ‘end of history’ feel to it: That banking and the economy have fundamentally changed. That we’ve learned from our errors. That animal spirits won’t be allowed to return. This mindset has had pros and cons: It’s starved investment under the auspices of ‘financial prudence’, a somewhat self-fulfilling prophecy which meant low growth encouraged low growth. But it also led to a more stable financial sector, the seventh-longest US expansion in history, and global equities flirting with all-time highs. That’s a debate for another Sunday.

 

What matters now is if this mindset changes. The passage of time, coupled with the signals of the new US administration, is raising the odds of increased aggressiveness. The return of fully fledged ‘greed’ is not our base case. But it is a serious enough possibility to weigh on our thinking and our recommendations. Further steps towards it are one of several factors that we think support a 1Q ‘sparkle’.

 

The path to greed seems surprisingly straightforward. Economic data, for the first time in years, are strong in the US, UK, Europe and China, and improving in Japan and broader EM. Inflation is rising (eurozone HICP is 1.8%Y), but not yet concerning (core HICP is 0.9%Y). Global earnings growth has turned positive again after 10 quarters of declines and credit is widely and cheaply available, with US credit markets seeing the most issuance ever in 2016 and European corporate bonds yielding 0.9%. Consumer confidence is the highest since 2001. Business confidence is the highest since 2004. US unemployment is 4.8%. G4 central banks continue to run exceptionally easy policy. Fiscal policy is already loosening in Japan and Europe, and is expected to loosen (significantly) in the US.

 

It is quite a cocktail – easy credit, easy fiscal and monetary policy, high confidence and a self-professed ‘business-friendly’ US administration. Asset valuations certainly aren’t cheap. But then again, how often do greedy markets care about valuations?

 

In short, we think a scenario where retail investors, corporates and financials all get much more optimistic at the same time needs to be respected, even if it’s not our base case outcome. Our preferred way to express that view is to own upside optionality on US and Japanese equities, where we think low volatility levels are underpricing a ‘greedy’ tail, and the possibility that such a scenario could see higher markets and higher volatility. It’s happened before. As TABX cratered and credit markets wavered in early 2007, the S&P 500 went on to make new highs, not peaking until October. Greed is a powerful force. We are trying not to forget that.