Morgan Stanley: “We Can Already See the Writing on the Wall”

Last Sunday, just before the Facebook plunge opened the selling floodgates for tech stocks (as also previewed here last weekend in “FANG + Apple Now Account For A Quarter Of The Nasdaq, And Some Are Getting Worried“) and the broader market, Morgan Stanley warned that “something was different this year“, specifically pointing out that as a result of escalating trade tensions and a global economy that is rolling over, the market may be priced beyond perfection, and that “2018 earnings expectations may be too high“, which however was good news for vol-starved hedge funds (which just suffered their worst month since January 2016).

When considering what that means for markets, it feels less like ‘morning in America’ than ‘happy hour in America’. In that sense, we’re pushing back on the notion that US policy actions have meaningfully extended the market cycle, instead arguing that markets have already largely reflected, and are currently pricing in, the benefits they delivered. Hence, we see more volatility to navigate as we work through the other side of the policy agenda. In US equities, for example, tax benefits are clear in their scale, but their use is murky. The nearly 8% move in 2018e EPS following the passage of tax reform aligns with our US equity colleagues’ estimate for full potential earnings benefit for the S&P from tax reform (~7.6%), leading us to believe that estimates are baking in a full flow-through of tax reform.

Morgan Stanley doubled down on the bearishness the very next day, when on Monday its chief US equity strategist Mike Wilson said that it is likely that the highs for the year are now in, that “when we look at our internal data combined with industry flows and sentiment, we think there is a strong case that January was the melt-up, or at least the culmination of it“, that “peak sentiment/positioning is behind us” …

… even as profits – the primary driver behind the recent market rally – peak: “earnings expectations might need to come down if we start to see some evidence of lower margins since consensus forecasts assume no operating margin degradation. That is another reason why we think the S&P 500 makes its highs for the year.”

What does Morgan Stanley think now? Below we present the latest take from Michael Wilson, who released the following Sunday Start report ahead of this week’s trading, which appears set for more volatility if only on purely statistical grounds – as some have noted, since 1990 when the S&P has lost more than 1.5% on a Friday, Monday saw a lower low 97% of the time, or on 90 out of 93 occasions.

From Morgan Stanley’s Michael Wilson:

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Cruel to Be Kind

Just two short weeks ago, investors were celebrating the remarkably strong US jobs data with few signs of inflation. It was, in fact, the ideal combination for risk markets with many proclaiming “Goldilocks is alive and well!” Indeed, on the day of the release, the S&P 500 was up 1.74%–the biggest single day increase since the day after the US Presidential election in November 2016. Global markets celebrated too with every regional equity market rallying sharply that Friday or the following Monday for those that were closed when the data were released.

But, that excitement was quickly met with disappointing price action over the following days. There was no follow through—a classic sign that the good news had exhausted rather than uncovered new buyers. It also coincided with the top end our 2650-2800 trading range in which we have been suggesting the S&P 500 would be stuck until the next positive catalyst could arrive—1Q corporate earnings.

We also pointed out in our Weekly Warm-up on March 12th that the market wasn’t properly focused on two very visible risks over the coming weeks—The Fed’s March meeting and the potential escalation of trade tensions initiated with the US administration’s steel and aluminum tariffs. Fast forward to today, and the good news is that the market is now fixated on both—especially the higher risk for a potential escalation of trade tensions—and we have quickly fallen all the way back to the low end of our trading range.

Our nearly 30 years of experience often makes us wonder if markets are really designed to play with our emotions. At the same time, we can’t help but think that our firm’s 2018 outlook for a “Tricky Handoff” is playing out to a T. To recall, this was very different from our much more bullish view in 2017 and out of consensus at the time of publication. The reality is that many of the things we expected this year are happening—higher volatility across rates, FX and equity markets, tighter financial conditions, risk adjusted underperformance of credit relative to equities, contracting equity valuations in the US, narrower breadth, and a peak in economic leading indicators and data surprises.

We have yet to see some of the more inauspicious things we expect later this year—including a peak in operating margins and y/y EPS growth in the US and perhaps other regions as well. However, we can already see the writing on the wall and are highly confident this becomes obvious to the masses by the end of 3Q, or 4Q at the latest. This suggests more tough times for equity investors, but we doubt it will be that easy as market tops tend to be particularly exhausting.

In the near term, we think global equity markets will eventually settle down about the Fed’s slightly more hawkish path of tightening they signaled last week and the elevated risks of a broader trade dispute. Specifically, the dot plot is slightly steeper but not enough to upset the apple cart in the next few months/quarters. Our fixed income strategists have been highlighting rising funding costs—led by LIBOR—as a near term risk, but they also expect reduced supply in April and a subsequent fall in these rates. This should provide another positive catalyst along with corporate earnings.

As for the risk of a broader trade dispute, we think the odds here remain low as well. We note that so far, the size of the tariffs announced—25% on up to $50-60B—amounts to just $12-5-15B in actual tariffs. More importantly, Europe has been exempted much like the President exempted Canada and Mexico from the steel and aluminum tariffs a few weeks ago. This all suggests these shots across the bow are being used more as negotiating tactics. China’s response, so far, is tepid with tariffs affecting just $3B of traded goods with the US.

While I acknowledge most disputes are typically started unintentionally, I also believe the tail event will be over discounted in the near term relative to the actual near term impact on earnings and growth. In addition, these kinds of events do tend to ebb and flow and right now it’s ebbing sharply which means it’s getting priced; and just like markets top on good news, they bottom on bad. There is also significant valuation support at current prices so we stick to our guns that higher price highs for the year are still likely in 2Q/3Q for US equity markets as forward earnings move higher; but it should continue to narrow, we expect leadership to get more defensive and the S&P 500 should likely end the year not far from current levels as earnings growth expectations decelerate from the evolution of the business cycle, tougher comparisons and tighter financial conditions. In the meantime, enjoy your Sunday!