Morgan Stanley's "Sunday Start", authord by Dominic Wilson, the bank's head of US equity research and the man who has been often called the most bearish analyst on Wall Street.
In last week’s Sunday Start, our Chief Economist and Global Head of Economics Chetan Ahya did a great job of laying out the case for not underestimating the potential impact of escalating trade tensions. While investors may be overly optimistic about a resolution, it’s not due to a lack of attention. The problem is that it’s hard to predict the outcome, given all the possible permutations.
I’ve been focused on another development that’s easier to analyze and may be more relevant for US equity and credit markets in the near term. The macro and micro economic data continue to deteriorate. Core durable goods orders for April remained weak. Capital spending has also disappointed, and our US economics team now forecasts 2Q investment to grow just 0.2%Q saar. April manufacturing PMI fell off sharply, led by new orders, with another fall in May in the headline number. US freight shipments have been soft all year, likely reflecting bloated inventories and weaker demand. To that point, 1Q retail company earnings came in weaker than feared, taking the average retail stock back near the December lows. Finally, as we discussed in our last Sunday Start, the key to any economic cycle is employment, and Thursday’s ADP results were very soft, as was Friday’s non-farm payroll number. This raises the risk of my core view playing out – that companies will do whatever it takes to protect margins, and while labor is the last lever they pull, they will use it if they need to.
The capital spending slowdown doesn’t surprise me, given last year’s boom. It’s right in line with our call for 2019 to be a year of payback due to the excesses in capex and inventory build last year. Many investors seem eager to blame the aforementioned weaker data points on the re-escalation of US-China trade tensions. Unfortunately, most of them preceded the early May pick-up in trade tensions. The economy was already slowing, and escalation potentially makes things worse – witness some of the comments in the Fed’s most recent Beige Book.
Speaking of the Fed, investors are now getting excited about a Fed cut after several governors and Chair Powell hinted that they are considering it. While this would be welcome news, a rate cut after a long hiking cycle tends to be negative for stocks, in contrast to a pause like in January, which is typically positive.
I’ve been vocal about the likelihood of US earnings and the economic cycle disappointing this year. Specifically, I’ve argued that the second half recovery many companies have promised and investors expect is unlikely to materialize.
Leading semiconductor and industrial companies have started to acknowledge this reality in their guidance while our economics team is now forecasting a meaningful 2H deceleration in US GDP to 1.6%Q annualized and flat global GDP at
3.2%Y. The good news is that markets aren’t completely impervious to the idea of slowing growth. All year, defensive and high-quality stocks have outpaced the broader indices. Finally, 10-year Treasuries and other government bonds have been making new highs all year, as investors seemed to be hunkering down for slower growth well before trade tensions re-escalated. If you listen to what the markets have really been saying this year, they seem to agree with our view that growth will disappoint whether there is a trade deal or not.
Therefore, we continue to recommend investors stay defensively positioned within their US equity portfolios, with overweights in areas like utilities and consumer staples. We also like the risk/reward of financials, given the low valuations, as a play on an eventual re-steepening of the yield curve as the Fed cuts rates. High-quality growth stocks should continue to do well, but you need to be more selective now because if growth slows further, many of them will struggle to deliver on high growth expectations, especially if this slowdown is the precursor to a recession. Defensive stocks should be less vulnerable because growth expectations are low and they trade more like bonds. We suspect that some technology stocks could be particularly vulnerable, given the slowdown in capital spending and high valuations that don’t reflect this risk.
Once expectations become more realistic and/or the stocks correct, we will get more constructive on US equity markets, including technology stocks, but not until then.