One Bank Sees ‘Likely Collision’ Between Powell, Stocks

The Fed “has a lot of wood to chop if they’re serious about removing the punch bowl,” Morgan Stanley’s Mike Wilson said, mixing metaphors in a Monday note.

One of the most vexing issues facing market participants at the current juncture is the idea that the Fed waited too long to normalize policy and as such is destined to exacerbate downward pressure on the US economy exerted by, for example, a waning consumption impulse as Americans grapple with surging costs for food and energy.

In short, the fabled “soft landing” will be very difficult to execute, if not impossible.

Read more: There Won’t Be A ‘Soft Landing’

Although Wilson didn’t rule out a benign outcome, he did underscore an important point: If the Fed somehow manages to deliver the number of hikes priced by the market over the next year while simultaneously commencing balance sheet runoff without triggering a recession, they’ll have succeeded in bringing financial repression to an end.

The figure on the left (below), shows the real shadow rate or, put differently, the policy rate adjusted for both inflation and QE. “The real Fed funds rate has been in a remarkably well-defined channel for almost 40 years,” Wilson wrote, noting that it bottomed in November, when Powell was renominated. He promptly executed a hawkish pivot that included formally denouncing the much maligned “transitory” characterization of inflation. “This is also the time when long duration equities topped and began what’s been one of the largest and most persistent drawdowns in growth stocks in history,” Wilson went on to say.

On the right is the nominal shadow rate. What you’ll note immediately is that it didn’t reach a new low during the pandemic. That’s the first time since the downtrend began that the nominal shadow rate didn’t touch a new low during a recession.

Commenting on the projected rates trajectory (red annotation in the figure on the right), Wilson wrote that, “If the Fed were to execute on such a path, it’s clear that Fed Funds Rate will break out of the 40-year downtrend [and] should the Fed also engage in… quantitative tightening, the Shadow Fed Funds Rate will rise even further outside this channel.”

Such an outcome, if delivered (and note that delivering almost by definition entails a soft landing, given that any downturn would likely mean not meeting market expectations for tightening), would “make us more comfortable with the view that financial repression is firmly in the rearview mirror,” Wilson remarked.

However, consistent with my contention that a soft landing is virtually impossible, especially if the Fed tries to deliver the tightening the market is currently pricing, Morgan Stanley went on describe a benign outcome as “a big ‘if’ at this point.”

“Growth was already at risk as we entered 2022 due to payback in demand, lapsing government transfers, generationally high inflation and rising inventories at the wrong time,” Wilson said, on the way to warning that “with the war in Ukraine leading to even higher commodity prices, the growth outlook looks even worse.”

For now, anyway, Morgan thinks the US economy can avert a recession. But earnings growth could well turn negative, especially considering the almost laughable prospect that corporate America can somehow manage to sustain record high margins in the face of sky-high input costs and wage bills, both of which are still climbing.

Wilson didn’t mince words, as he usually doesn’t. He described Morgan Stanley’s conviction level around the Fed’s intent to raise rates and wrestle inflation lower as “high.” As far as the notion that any war-related hit to growth might derail the Committee’s best laid tightening plans, Wilson said that in his view, the Fed “will keep a watchful eye on the data but err on the side of hawkishness given the state of inflation,” which he described as “now arguably out of control.”

The takeaway for equities, and especially long duration shares, is suboptimal, if not downright grim. “This likely means a collision with equity markets this spring with valuations overshooting to the downside,” Wilson said.