Although you may be inclined to exasperation vis-à-vis the impossibility of trading a market hostage to geopolitical headline hockey, attributing all of the price action to the standoff in eastern Europe might not be wise.
That’s according to Morgan Stanley’s Mike Wilson, who suggested investors consider skating ahead of the proverbial puck by focusing on the outlook for growth and corporate profits.
To be clear, there’s no arguing that Russia-Ukraine headlines drive the price action from minute to minute. Earlier this month, SocGen said investors were underestimating the extent to which markets reacted to an upsurge in Ukraine headlines in January. The argument wasn’t that the Fed didn’t matter or even that the Fed wasn’t the most important issue. Rather, the argument was that the anomalous outperformance of intraday vol was likely attributable to geopolitical tape bombs. That seems prescient less than two weeks later, even as the bank’s hopeful suggestion that tensions might ease unfortunately didn’t pan out.
Additionally, mechanical flows associated with dealers’ hedging needs are magnifying intraday swings. The combination of the two (Ukraine headlines and mechanical flows tied to options) is largely responsible for a head-spinning tape.
But stepping back from the minute-to-minute and hour-to-hour action, it’s Fed policy and any growth/profit slowdown that matters most, according to Morgan Stanley. “We think Fed tightening is well understood at this point even if it’s not fully discounted in multiples,” Wilson wrote, alluding to the fact that even after a second correction for the S&P in two months, a serious index-level de-rating remains elusive. “From here, the depth and duration of the ongoing correction will be determined primarily by the magnitude of the slowdown in H1,” Wilson went on to say.
One problem is that American consumers — “resilient” though they may be — are facing “generationally high inflation in just about everything [they] need and want,” as Wilson flatly put it. The University of Michigan’s sentiment survey reflects severe consternation in that regard, even as retail sales printed a large upside surprise for January and flash reads on IHS Markit’s PMIs for February were notably ahead of consensus (figure below).
There’s no need to overthink things. The subheading in the chart says it all. Inflation is undermining confidence, even as PMIs appear to be perking up as Omicron recedes.
But Wilson isn’t just worried about the consumer. In his latest, he returned to a recurring theme: The downside of supply-side normalization.
Although an alleviation of the shortages which came to define the post-COVID era would be welcome news in many respects, Wilson continued to warn that normalization “could also lead to a return of price discounting for many goods where the inflationary pressures have been the greatest.”
Why does that matter? Or, more aptly, why is it bad? Well, because it could crimp margins and undermine demand. “If improved supply reveals a much greater level of double ordering than what is anticipated by companies [the] demand picture may not be as ‘robust’ as believed,” Wilson cautioned, echoing a number of recent notes which communicated the same risk.
Again, all of that is a fundamentals story, and so is the notion that US equities are vulnerable to a deterioration in profits and sales growth. The correlation between equities, EPS, revenue and margins surged back into positive territory of late, and the same can be said of revisions breadth (figures below).
“This is important… because we expect these indicators that are currently highly correlated [with] equity returns to decelerate in the coming months,” Wilson warned.
Indeed, Morgan’s leading EPS indicator now flags a marked deceleration, while revisions breadth is already fading fast (figure below). Morgan sees this trend sticking around “at least” through first quarter results.
It’s likely, Wilson concluded, that management teams will start to guide lower as costs rise and aggregate demand slows. A ratio of negative-to-positive guidance is already the most elevated in almost three years.
As for Ukraine, Wilson said the bank’s US equity strategy team “doesn’t have a strong view.” The word “Ukraine” came up just nine times in 32 pages. Wilson conceded an escalation could “obviously” make any slowdown “even worse,” but if you ask Morgan, “preexisting fundamental risks” around earnings and growth “will be the primary driver” going forward.
I remember the period of inflation that spawned Nixon’s price controls and one consumer outcome was that no one would buy anything except when it was on sale. That led to firms faking sales and adjusting product sizes to keep nominal prices from rising by selling us 14 oz of sausage for the same price as a pound had been. Everything got smaller. The the sale would be to leave the price alone and add “2 extra ozs free) briefly. However, starting then, consumers fell in love for sale prices and a new pattern was formed. This was reinforced in the inflation of the 80s, the era of the rebate. Man, I hate rebates. People have put up with this latest bout with inflation and I suspect it won’t be long until we get another set of strategies from companies to cover it up. BtoB inflation will be a tougher nut.
Corporate America has followed that playbook ever since, to the point where there are many products out there that can’t be “shrunk” any further w/o disappearing.
Agree. Trying to trade the Ukraine-invasion triggered swings is not a great idea for most investors. Focus on what stocks care about – corporate profit outlook over the coming year.
There is a lot of discussion about margin compression these days simply because profits are so high and the idea that inceasing labour costs might not get passed on, thereby compressing margins. It is useful to recall that margins only really contract in recessions, so if one has this margin compression view they are actually saying that they see recession coming. That may or may not happen, certainly the inversion of the ED strip is worried about a Fed policy mistake, but margins are unlikely to compress as long as growth holds up and so far the modest revision lower in consensus GDP forecasts does not suggest that and if you add in inflation for a nominal forecast, these are holding up if not going higher. However, I would caution none of this has much bearing on the path of equity markets in the near term which are hostage to the Fed cycle and Ukraine developments.