‘This Cycle Does Not Defy All Precedent’: Morgan Stanley Doubles Down In Mid-Year Outlook

On Monday, in the course of documenting a burgeoning tug-of-war between two divergent narratives around the prospects for the reopening push in the wake of rising COVID-19 infection rates in some states, I noted that investors were just becoming comfortable with the economic revival story.

“Were” (past tense), because that story is now in jeopardy from what some are prepared to call a “second wave” of the virus. Indeed, fresh headlines out of Beijing on Tuesday suggest residents at high risk of infection will not be allowed to leave the city, which is rushing to contain an outbreak tied to a food and vegetable supply center. City officials have locked down seven residential compounds located near the market, the district government said in a statement.

For US investors, headlines like those (from abroad) are adding to angst generated by a resurgence of cases at home, specifically in Florida, South Carolina, and Texas. Throw in some of the worst domestic unrest in decades, and you’re left to ponder an unappealing macro backdrop.

Of course, central banks’ still have everyone’s back, and apparently, the market is more than willing to respond to Fed “announcements” even when there’s little to no new information in them.

“Central bank support, without exaggeration, is off the charts”, Morgan Stanley writes, in a mid-year outlook piece called “Trust, but Verify”.

“The Fed is buying more assets relative to GDP than QE1, 2 and 3 combined”, the bank’s Andrew Sheets notes, adding that “together, the Fed and ECB look set to buy roughly equal to all net supply across European and US sovereign and corporate debt this year”.

(Morgan Stanley)

It would be ironic (albeit fitting and wholly predictable) if things began to unwind anew just as more folks were coming around to the possibility that, at least from a near-term economic perspective (i.e., leaving aside crucial long-term concerns around protectionism, de-globalization, heightened nationalism, etc.), the COVID-19 crisis was more “growth shock” than recession.

For their part, Morgan Stanley is sticking with the notion that developed markets will recover faster than many market participants believe.

Sheets continues to suggest that DM growth “could recover to pre-recession levels by the end of next year. While the projected “eight-quarter ‘time to recovery’ would be about twice as fast as what followed the GFC”, he reminds you that it would be “similar to the US recessions of 1973 and 1981”. So, it’s true that the bank’s base case is more optimistic than some, but it’s not wildly optimistic by historical standards.

(Morgan Stanley)

“Every recession and cycle is different, but we challenge the notion that this one defies all precedents”, Sheets goes on to say.

That’s a pretty bold declaration, even if he doesn’t mean for it to be. If you follow Morgan’s outlook, you know that this has generally been their take for a while now, and Sheets contends that history “can still act as a guide” for this downturn, a notion many would challenge.

On top of that, Morgan says that “fundamentals, valuations and technicals all remain ‘better-than-average’ for forward-looking risk premiums”.

On the fundamentals front, the bank essentially argues that the levels on key indicators simply don’t matter as much as the trend right now. That’s not a controversial claim. It’s just a reflection of the current reality, in which the market is more interested in the trajectory of things than whether a given print from April or May counts as a black swan or a psychedelic swan. Historically, Sheets observes that “an environment where bad data are improving isn’t bad” for stocks (on a forward return basis).

If you’re wondering whether Morgan is sticking with the pro-cyclical rotation theme, the answer is definitely yes. To wit, from their outlook:

Importantly, cyclical troughs often mean major changes in market leadership and performance. Early-cycle environments often see bear-steepening of the yield curve, rising inflation expectations and better relative performance from both small-caps and cyclicals. All are investment strategies we currently like.

Most of that was working great for the latter part of the rally from the March lows. The rotation trade took a breather last week, though, as a sudden bout of risk-off sentiment prompted bull flattening and a rough week for the rotation trade.

In case you didn’t get the message over the weekend (see here and here), I’ll just take this opportunity to drive the point home one more time. Tales of Robinhood retail mania aside, sentiment and positioning are not stretched. Morgan calls it “restrained”, and employs the following visual to illustrate.

(Morgan Stanley)

Ultimately, the bank says that headed into the back half of the year, the best risk/reward is in corporate, securitized and EM credit. Not surprisingly, they believe the risk/reward of government bonds is “poor”, while the risk/reward of equities is “mixed-to-positive”.

Of course, there are risks, and everyone knows what they are – including Morgan. Here is Sheets’s quick evaluation of three key risk factors:

  • COVID-19: Despite an expanding narrative that ‘the disease is behind us’, global case counts are still rising. While fatalities are falling as health systems adapt and new infections are skewed towards younger cohorts, the menace has not gone away. Specifically, Morgan Stanley estimates assume that US cases begin to rise again from mid-July, a delayed response to social distancing measures being lifted. Viewed from a distance, we currently believe that a ‘second wave’ will be small. But when it starts, it won’t be possible to know how far it will rise, and the effect on consumer and market psychology could be significant. After all, we’re believers that trend often matters more to markets than level.

  • The US elections and trade: Asset markets, particularly US ones, have often seen worse-than-average returns in the three months ahead of competitive US presidential elections. The reason is intuitive; from three months out, ‘wait and see’ becomes tempting for both investors and companies that would otherwise take action. We expect investors to treat the US 2020 race as a close election, between two candidates with extremely different policy platforms. Ironically, despite these differences, one issue where we think that both candidates will sound similar is US-China trade. We think that the risk of an escalation of trade tension rises as the election approaches.
  • Fiscal policy doesn’t follow through: Our current base case is that the US will pass a further US$1 trillion stimulus package between now and July and that the European Union will agree on a €750 billion recovery fund very similar to the current French-German proposal The failure or dilution of either and, more broadly, a premature shift back towards belt-tightening would be a major risk. A misguided focus on debt/GDP ratios and a premature shift to fiscal austerity was a major driver of why the post-GFC recovery was so weak.

To be clear, this hardly covers it. Morgan’s outlook is nearly 70 pages long, and as is the case with all quarterly, semi-annual and annual outlook pieces, the bank lays out dozens of recommended trades for clients, and makes specific calls on every asset and benchmark known to mankind.

But the thrust of it is captured in the very first bullet point on the very first page. To wit:

Trust, but verify, that this cycle is more ‘normal’ than appreciated: The patterns that preceded the recession had normal late-cycle characteristics. The manner in which markets bottomed in March followed prior recessions. The market is still underpricing the extent to which the recovery could also follow that traditional playbook.

Some will doubtlessly take issue with that, and time will tell who was correct.

Oh, and for the bearish among you, I regret to inform you that Mike Wilson isn’t going to be much help when it comes to confirmation bias this time around. He turned constructive a while ago (a good call, to be sure) and he’s still constructive.

“We turned bullish in mid/late March on the thesis that recessions mark the end, rather than the beginning, of bear markets”, he says, a few dozens pages in.

“Price action since then has played out in line with our recession playbook, confirming that it isn’t different this time”, he adds, before delivering the final blow to the cadre of doomsayers who jumped on his coattails in 2018 when he correctly predicted the correction that year.

“We remain firmly in the camp that the economy is likely to experience a V-shaped recovery, which is exactly what the equity market is foreshadowing”, Wilson writes.

His 12-month base case target for the S&P is now 3,350.


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