Be careful, it could be a trap.
That’s one way to read the latest from Morgan Stanley’s Mike Wilson, who, in a Monday note, cautioned against interpreting recent declines in oil prices and yields as evidence of peak inflation. “In our view, both… are being driven more by fears of an economic slowdown,” he said.
That’s an important distinction, because only peak inflation opens the door to a less aggressive Fed. I touched on all of this in “All That Matters.”
The problem with rallies like last week’s sharp move is straightforward: They reverse progress made towards fair value. If earnings revisions are inevitable (and I think they are), and the economy is destined to at least flirt with recession (which it already is), then stocks are mispriced. Perhaps badly so. Absent a more risk-friendly Fed (which, again, requires concrete evidence of peak inflation), it’s very difficult to justify re-rating right now.
“The S&P 500 is trading back at 16.3x or 1 turn higher than where it was at the prior week’s lows… which seems unusual given the growing concern about earnings,” Wilson wrote, adding that “even taking into account the fall in 10-year yields, the equity risk premium is back to 300bps,” which he said “makes little sense” given the likelihood of negative revisions and heightened risk of a broader economic downturn.
Bonds, he suggested, are just now coming to terms with a macro reality that’s readily observable in, to name two, the copper/gold ratio and the economic surprise index (see the figures, below).
Wilson also flagged the ~50bps drop in terminal rate pricing. Regular readers are well apprised of how all of this played out last week. I summarized it in “Hard Landing Panic Has Markets Rethinking Central Bank Bets.”
Because rising yields (and elevated rates vol) have been the bane of stocks’ existence in 2022, the nascent bond rally predicated on recession fears is being viewed as a bullish near-term catalyst for equities in true “bad news is good news” fashion.
The problem with that in 2022 is that the Fed isn’t operating in growth-conscious mode. They’re operating under what amounts to a single mandate where the inflation fight takes precedence over all other concerns. After a dozen years of the vaunted “Fed put,” markets are having a very difficult time coming to terms with that.
The stark reality is that for now, falling yields and recession worries are just that — they’re not a precursor to a more risk-friendly Fed until there’s evidence that inflation is on track to recede. Officials have made it abundantly clear what would constitute such evidence. They want to see a series of cooler monthly readings. We don’t even have one yet.
“For falling yields to [be] positive for equities, we’d likely need to see a continuation of falling yields in the context of cresting inflation pressures, an associated less hawkish Fed policy path, more durable economic growth than we expect and a re-acceleration in earnings revisions,” Wilson said Monday.
In other words: We’d need to see a soft landing. Wilson called such a conjuncture “feasible, but not likely,” on the way to reiterating that the current rebound in US stocks is probably just a bear market rally which will eventually bow to “the reality of lower earnings” on the way to lower lows.
“The only question,” he went on to write, “is whether we have a soft landing or a recession.” In the context of the bank’s equity forecasts, that’s the difference between the S&P bottoming between 3,400 and 3,500, or falling near 3,000.
Wilson’s analysis is pretty compelling. One caveat I have is that Fed policy and interest rates are no longer one in the same. Many rates have moved far higher than the 150-175 FOMC tightening because of spread widening and anticipating Fed moves. For instance mortgages are +300 to cite one market. This is one adjustment that has already rippled through some markets- home builders are off quite a bit more than the stock market in general. Do home builders have more downside? Perhaps, but they may already be trying to form a bottom. It seems that we are seeing as much rotation in stock sectors as we are seeing direction now. There may be more downside in some sectors- especially late cycle ones like energy and materials. But in the not too distant future, we could see some early cycle sectors (thinking financials maybe) bottom and turn around sharply. The dollar index has also been strong- that would suggest that Fed policy is gaining traction. This could be a case of the cycle turning more quickly than folks anticipate. Stock market sells off in one final swoop, and Fed tightening cycle concluding in fairly short order. I expect we will see this play out in the second half of this year, and we shall see if this scenario plays out.
@RIA – some good points there. But so far, we’ve been seeing a lot of rotation versus total “get me out” selling of everything. We are all still acting as if the Fed has not abandoned their 2009-2021 playbook. To cite an obscure movie title, Things Change.
I’m of the same mind as RIA. I don’t know that we need to necessarily see a full-on capitulation at this point barring another significant negative shock. Seems to me like one of those situations where everyone’s waiting for that moment of panic that might never arrive and the market will have already left the station by the time everyone realizes it. That being said, if there is another inflationary shock, all bets are off and I fully expect pandemonium. Any other type of shock and we might get another dose of opiates and it’s off to the races.
Bad news is now just bad news. Good news remains bad news. We’re bereft of news-related aphorisms. We can still rest on “no news is good news,” though it’s cold comfort, because no news implies uncertainty and we all know how markets feel about that!