Over the weekend, I trudged into the macro rough after a drive aimed at a simple exposition on real rates and equities missed the fairway.
I do that all the time. If I set about writing something relatively straightforward and my digital pen strays, I let it go wherever it wants. That tendency drove at least one former employer crazy, but I didn’t care. When you’re irreplaceable you can do whatever you want. Then, one day, you just quit. Because you can. But mainly because you’re inebriated. And also because you already pocketed your bonus and there’s no clawback provision.
Anyway, one key takeaway from the linked article was that rising real rates are a headwind for equities. That’s not exactly a groundbreaking observation, but the point was to contextualize recent rate rise vis-à-vis various macro crosscurrents. Later, I talked a bit about threats to margins ahead of Q3 earnings season.
On Monday, Morgan Stanley’s Mike Wilson revisited two scenarios for a correction in US equities, one of which involves the Fed tightening as inflation pressures build and the labor market heats up, prompting a 10-15% de-rating, some of which is offset by earnings growth. The net effect is a 10% correction for the S&P. The second scenario finds the Fed tightening into a slowdown. As profit momentum wanes alongside the cooling economy, there’s no offset, and stocks fall 20%.
For Wilson, the September FOMC was “more hawkish than expected,” and that’s partly to blame for the ensuing rise in real rates and the dollar (figure below).
That represents a tightening of financial conditions which, of course, bodes ill for risk assets. Like equities. It’s especially bad for richly-valued corners of the market.
Wilson distinguishes between that impact (i.e., pressure on financial assets) and the notion that at this stage, there’s virtually no read-through for the real economy. “This distinction is important because the Fed is much more focused on the economic impact of tapering than its effect on equity markets — assuming credit remains bid,” he wrote. (I’ll roll out the obligatory joke: If credit doesn’t stay bid, the Fed last year demonstrated its capacity to correct that problem.)
One cornerstone of most bullish outlooks is that once the Delta variant recedes, economic activity will reaccelerate. Wilson disagrees. “We believe the greater than normal slowdown is due to the greater than normal amplitude of this economic recession and recovery and extreme operating leverage that is likely to reverse due to supply constraints, higher costs and taxes into next year,” he said Monday.
Ultimately, Wilson suggested “faster tapering” alongside a sharper-than-expected economic deceleration presages a correction in stocks that’ll be “greater than 10%.”
One mitigating factor is the willingness of individuals to backstop the market. “Backstop” is a euphemism for buying the dip, something retail investors have done “relentlessly” in 2021, Wilson remarked, on the way to suggesting the fate of the bank’s correction call hangs on the mood of Joe E*Trader and his millions of friends.
“We find it worth noting that the Evergrande dip two weeks ago was bought but is the first dip of the year that has lacked follow through to the upside, at least so far,” Wilson wrote.
“Friday’s close was the first good one all week and suggests retail hasn’t given up the fight,” he added, noting that Morgan will “keep an open mind for now and will be watching this closely as earnings season begins.”
Once again, I’d gently suggest that you really need to take account of systematic flows if you’re looking to explain price action during weeks like the one we just had.
Sentiment has been damaged. Repair will take awhile. When it does, expect the market to rebound and probably go to new highs absent a policy mistake. Likely we will have to correct more first though.
I’m with Ria. I expect there will be some form of rotation. Fingers crossed that my small-caps gain favorable attention in the process.