You Do The Math

There’s considerable angst about the prospect that the Fed is too late.

Not so much too late to do something about inflation. Some are concerned about that too, but ultimately, monetary policy’s capacity to make a difference is probably limited anyway given what’s driving inflation in the US.

Rather, too late in the sense that the economy is decelerating and thus can’t “fund” the Fed’s efforts. If policy doesn’t manage to shift the entire curve higher, the flattening impulse could create a self-fulfilling “growth scare” optic.

“The dynamic further out the curve has already begun showing signs of apprehension regarding the global growth ramifications from a decidedly less accommodative Fed,” BMO’s Ian Lyngen and Ben Jeffery wrote Monday. “Nonetheless, the push toward a higher global rate environment is well underway, which brings into question the extent to which 10- and 30-year Treasurys will be able to achieve further upside in rates,” they added.

One bank expects the juxtaposition between hawkish policy and slowing activity to become stark over the next several months. That’s the gist of the “Winter Is Coming” thesis as expounded by Morgan Stanley’s Mike Wilson.

He elaborated in a Monday note. Clients, apparently, have asked Wilson for evidence that PMIs are poised to slow, consistent with the commentary that accompanied last week’s missive. He pointed to a hodgepodge of harbingers, including a ballooning spread between ISM new orders and inventories and a rather dramatic drop in the ratio of industrials’ forward multiple and that of the S&P (figure below).

The crucial point is the read-through of a falling ISM PMI for the equity risk premium.

Wilson’s analysis shows that, over time, ISM has quite a bit of explanatory power for the ERP. He utilized that relationship, alongside US yield forecasts from Morgan’s rates team, to assess the likely path for multiples in the service of answering two key questions: Assuming PMIs do fall, what’s fair value and what would it be if rates continued to rise?

The sensitivity analysis shown in the table (below) gives you a sense of where stocks “should” trade given different PMI/yield permutations. As it turns out, current levels on both the (composite) PMI and 10-year yields line up well with spot.

“So on this score, as things stand today, the market is fairly priced,” Wilson wrote.

The problem (obviously) is that Morgan thinks PMIs are likely to decelerate going forward. Assuming a PMI in the mid-50s and unchanged 10-year yields, stocks would de-rate and fall to somewhere around 4,000.

Importantly, even if PMIs don’t decelerate meaningfully, a rise in 10-year yields to 2% (Morgan’s target for the first quarter) still puts the S&P at 4,000.

The only way we get to SPX 4,900 is with a composite PMI of 64 and a 40bps decline in 10-year yields. Needless to say, it’s difficult to imagine such a conjuncture in the current circumstances.

Wilson conceded that the bank’s ISM and yield projections could both be wrong, but the takeaway is that if i) the forecasting approach makes sense, and ii) even one of their two assumptions is correct, fair value is considerably lower than spot.