Authored by Michael Wilson, Morgan Stanley's Chief US Equity Strategist
No doubt the past six months has been a wild ride, with one of the worst fourth quarters on record followed by one of the best starts to a new year. It’s also been across all asset classes and regions, a true beta event. The popular explanation going around is that the fourth quarter sell-off was just a technical event, the result of an unnecessarily aggressive Fed and trade tensions between the US and China. With both of those problems now ‘fixed’, markets can go back to where we were before these were concerns. As such, new highs for equity indices and tighter spreads for credit can’t be far away.
To take it a step further, many are even using a formerly popular narrative of ‘Goldilocks’ to describe the current situation, which goes something like this: China’s fiscal stimulus, which is finally showing signs of gaining traction, and the resolution of US-China trade tensions should be enough to stop and modestly reverse the rollover in growth in the global and US economies. Meanwhile, the Fed’s aggressive pivot on monetary policy means financial conditions and interest rates are under control. In many ways, it’s just a repeat of early 2016 which puts us back into the not too hot, not too cold environment that dominated the 2013-17 period during which a barbell of growth and defensive stocks dominated. But, what if growth isn’t ‘just right’ and Goldilocks is the wrong fairy tale?
I see other reasons for the growth slowdown that have been underappreciated by most market analysts, especially in the US. First, as we’ve noted since the day it was passed, the timing of the fiscal stimulus was highly questionable. While corporate tax cuts is perhaps a good supply-side policy that could lead to much-needed investment and subsequent productivity gains, enacting it at a time when you are already at full employment is typically not a great idea. Sure enough, the US economy ran too hot in 2018 with GDP peaking at 4.2% growth in 2Q, well above potential GDP of just 1.5%. We’ve argued since last summer that such overheating was bound to lead to some excesses and the absorption of spare capacity faster than what would have happened in the absence of this fiscal stimulus. Corporate capex and buybacks also got a significant boost from the corporate tax cuts and repatriation of overseas cash, and that is unrepeatable.
When we published our margin risk note for US equities last October we were particularly focused on labor costs and logistics as two areas that were seeing tightness and would likely squeeze corporate profitability. Based on 4Q earnings results and forward guidance, the impact from higher costs is definitely starting to bite. Specifically, consensus EBIT margin expectations for 2019 have fallen by 70bp since October, which is the biggest decline since the last earnings recession in 2015. While it’s difficult to measure the contribution from each source of incremental cost, we are confident it’s not all due to supply chain disruption from US tariffs on Chinese goods. Instead, our contention continues to be that the majority of the cost pressure is the result of the economy running too hot last year which has led to higher labor costs among other things (see Exhibit). This essentially tipped over the profits cycle. Furthermore, the de-escalation of trade tensions with China and a pausing Fed will not alleviate those pressures, in our view. It’s also very different than in early 2016 when goldilocks was alive and well.
Indeed, corporations seem to agree as we are now seeing the inevitable reaction from managers to the margin squeeze. Last Thursday, private outsourcing firm Challenger Gray & Christmas reported job cut announcements spiked last month to the highest monthly total since July 2015. This was followed up on Friday with one of the weakest payrolls numbers and the highest wage cost reading since the economic recovery began in 2009. The profits recession is more a function of the business cycle overheating than most appreciate, which means labor markets may soften further along with capital spending until the profits recession ends which is unlikely after just one quarter of modestly negative growth. It also means there probably isn’t as much slack in the economy as many investors think and as depicted by the cost pressures now evident. Rather than Goldilocks, perhaps we should be talking about Hansel and Gretel – a fairy tale about the dangers of an unwholesome appetite as a means of survival – i.e., chasing prices higher and justifying it with the wrong narrative.