Morgan Stanley: "The Debt Ceiling Worries Us Most"

In the latest Sunday Start report from Morgan Stanley's Andrew Sheets, the bank's chief cross-asset strategist looks at the current state of the market - "the S&P 500, Russell 2000 and NASDAQ have hit all-time highs. Volatility has plunged back down near all-time lows. Credit is tighter and yields have been stable" - and asks the same question posed by virtually everyone else in recent weeks : "what rattles this market. What breaks the egg?"

Sheets, like the bank's equity research team (which recall believes the current market is a rerun of 1999 and sees up to another 30% surge in stocks) remains optimistic saying that "risks don't warrant a defensive view yet", and adds that "with longs concentrated in DM equities and EM fixed income"... "no one wants to be that complacent investor at the highs, and good times are always the best time to think about what can go wrong.

On the other hand, Sheets highlights one rising risk, namely his "high conviction that markets have passed the point where bad data can be offset with promises of further easing. But so far this doesn’t matter, because growth in 2017 has been surprisingly good. Our economists see 2Q global GDP at 4.3%Q, the highest reading since 4Q10. Weaker growth will crack the egg, but we’re not seeing it yet."

A second risk mentioned by the X-asset strategist: "valuations and earnings. High stock valuations and strong earnings can be OK (see the early 1960s and late 1990s). High valuations and poor earnings is trouble. A disappointing 2Q earnings season would be a clear catalyst to push the market lower. But there are a few reasons why we don’t think that happens."

A third risk is that inflation, largely benign and disappointing in recent months, returns: "for now, soft inflation is giving DM central banks cover to keep real rates deeply negative. This won’t last forever; our economists forecast the trough in US core PCE in September, inflation in Japan and the eurozone to pick up materially in 1H18 and China."

Risk number 4 to Sheets: aggressiveness. "Growth with easy money is a cocktail for all manner of problems, from ill-advised M&A, to excessive bond issuance, to extended investor positioning. All are potential egg-crackers." But again (and you may sense a theme here) Morgan Stanley don’t think they’re negatives yet: "M&A volumes in the US and Europe are still only half the 2007 peak. US credit has yet to show strains from oversupply (although we remain cautious, seeing poor risk/reward). Our prime brokerage team tells me that hedge fund net positioning remains near its 10-year average. We’re watching all these closely."

Which brings us to the biggest concern for the bank which recently beat Goldman Sachs in FICC revenue for the second straight quarter: politics, in general, and the debt ceiling in particular.

One reason why we may not be seeing more aggressiveness is our final risk – politics. Multiple failures in the US to pass healthcare legislation, despite single-party control, raise questions about a whole host of other issues, from the debt ceiling, to the budget, to taxes. Meanwhile, news reports suggest that the ongoing probe by Special Counsel Robert Mueller is widening.

Finally, here is what Sheets - along with many others, including the T-Bill market - believes is the biggest immediate risk to the market:

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks. But on the other issues, we’re more relaxed. The Senate’s Healthcare bill had an approval rating of 17%, so we doubt its failure would be a hit to consumer confidence. The Special Counsel’s investigation, whatever the outcome, will likely take considerable time. Our economic baseline was already cautious with regard to fiscal stimulus, a long-held view of our policy team. And while tax cuts could boost the market temporarily, they could also lead to a more hawkish Fed, a classic ‘be careful what you wish for.’

Incidentally, we agree with Sheets that the debt ceiling is fast emerging as the biggest downside risk catalyst, and one which has a tangible date: mid-to-late September. In light of the dire state of political discourse in Washington, and Trump's inability to form a political compromise, it is no surprise why the October 19, 2017 T-Bill yield spiked in recent days...

... and why the October 19, 2017 Bill Spread has blown out....

... as more traders begin to grasp what a failure to pass the debt ceiling, if only temporarily, would mean for the US.

* * *

Andrew Sheets full note is below:

What Breaks the Egg?

 

I didn’t win the 4th of July egg-toss, and never really came close. Our egg cracked easily, which couldn’t be a worse analogy for markets over the last three weeks if I tried. The S&P 500, Russell 2000 and NASDAQ have hit all-time highs. Volatility has plunged back down near all-time lows. Credit is tighter and yields have been stable. So what rattles this market? What breaks the egg?

 

We remain constructive, with longs concentrated in DM equities and EM fixed income. But no one wants to be that complacent investor at the highs, and good times are always the best time to think about what can go wrong. What follows is where we see risks, and why we don’t think they warrant a defensive view (yet).

 

Let’s start with growth. I believe, with high conviction, that markets have passed the point where bad data can be offset with promises of further easing. But so far this doesn’t matter, because growth in 2017 has been surprisingly good. Our economists see 2Q global GDP at 4.3%Q, the highest reading since 4Q10. Weaker growth will crack the egg, but we’re not seeing it yet.

 

This brings us to a second risk: valuations and earnings. High stock valuations and strong earnings can be OK (see the early 1960s and late 1990s). High valuations and poor earnings is trouble. A disappointing 2Q earnings season would be a clear catalyst to push the market lower. But there are a few reasons why we don’t think that happens.

 

First, strong 2Q global GDP should be a tailwind to revenue. And where that growth has been most disappointing (the US), a weak dollar should provide a tailwind. My colleague, Graham Secker, has specific concerns in places like European cyclicals, where inflows have been high, a stronger EUR is a challenge and early earnings misses have been punished. But broadly, we see earnings as more likely to be a positive than negative global catalyst this year.

 

Strong global growth usually means policy tightening, another candidate to break the egg. But for now, soft inflation is giving DM central banks cover to keep real rates deeply negative. This won’t last forever; our economists forecast the trough in US core PCE in September, inflation in Japan and the eurozone to pick up materially in 1H18 and China CPI to climb steadily over the next 12 months. Our base case is that rising inflation is next year’s problem, but markets could react sooner than we expect. We’re watching this closely.

 

Strong growth and easy policy, of course, present another risk: aggressiveness. Growth with easy money is a cocktail for all manner of problems, from ill-advised M&A, to excessive bond issuance, to extended investor positioning. All are potential egg-crackers. But again (and you may sense a theme here) we don’t think they’re negatives yet.

 

M&A volumes in the US and Europe are still only half the 2007 peak. US credit has yet to show strains from oversupply (although we remain cautious, seeing poor risk/reward). Our prime brokerage team tells me that hedge fund net positioning remains near its 10-year average. We’re watching all these closely.

 

One reason why we may not be seeing more aggressiveness is our final risk – politics. Multiple failures in the US to pass healthcare legislation, despite single-party control, raise questions about a whole host of other issues, from the debt ceiling, to the budget, to taxes. Meanwhile, news reports suggest that the ongoing probe by Special Counsel Robert Mueller is widening.

 

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks. But on the other issues, we’re more relaxed. The Senate’s Healthcare bill had an approval rating of 17%, so  we doubt its failure would be a hit to consumer confidence. The Special Counsel’s investigation, whatever the outcome, will likely take considerable time. Our economic baseline was already cautious with regard to fiscal stimulus, a long-held view of our policy team. And while tax cuts could boost the market temporarily, they could also lead to a more hawkish Fed, a classic ‘be careful what you wish for’ per my colleague Michael Wilson.

 

Weaker growth, disappointing earnings, hawkish policy, over-aggressiveness and political mistakes are all candidates to break the current tranquility. We like long EURAUD as a combined hedge against tighter policy or weaker growth than we otherwise expect. Our rates strategists like owning long-dated US vs. EU duration, given attractive risk/reward heading into a debt ceiling fight. Against that, we’d maintain a positive overall stance, with longs concentrated in DM equities and EM fixed income.

Comments

Pop3y3too Sun, 07/23/2017 - 17:37 Permalink

Oh, no! We only have SEVEN WEEKS before it all implodes with the debt ceiling. We're worried, so bigly worried and you should be, too. . __ .  déjà vu.   I say bring it on, already, ffs.  

1033eruth Sun, 07/23/2017 - 17:43 Permalink

There is no DEBT CEILING.  Its an exercise in political posturing.  Those fucks know exactly what they are going to do for every single last debt ceiling.  How many "debt ceilings" have we had now?  Exactly, which means there is NO DEBT CEILING.

HRH Feant2 (not verified) Sun, 07/23/2017 - 17:47 Permalink

I agree. It is a concern. What if this turns into a big game of chicken and they start digging in the crazy drawer?

Yen Cross Sun, 07/23/2017 - 17:54 Permalink

  WTF exactly is "EM" fixed income? Is that some kind of joke?  Paying for yield/ in some third world banana republic shithole is a sound investment?

Rick Cerone Sun, 07/23/2017 - 18:11 Permalink

If the quadrillions in dervivatives doesn't make you sick, the debt ceiling wont, MS. BTW, return the $40 trillion stolen from the US Treasury before the people get upset.

JailBanksters Sun, 07/23/2017 - 20:11 Permalink

Oh Gawd, Morgan just stop, stop it.I know, you are only aiming your Fear, Unceainty and Doubt at Government.But you're just trying to sell horseshit as bullshitThe world won't explode because the Government is going to stop borrowing money that doesn't exist to pay for things they want today. 

Silver Savior Mon, 07/24/2017 - 01:49 Permalink

I wish they would do away with the debt ceilings and just print to infinity. Might as well get something out of what's left of the shitty dollar. I will be glad when this peice of shit is replaced by anything. 

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