‘Danger Zone’ Markets Need Fed To ‘Print Dollars’: Wilson

Last month was especially cruel to equities. September lived up to its nefarious seasonal reputation.

As Morgan Stanley’s Mike Wilson wrote Sunday, stocks’ dastardly performance this year meant the bar to clear for a “bad” month was pretty high. In that context, the S&P’s 9.2% drubbing (the worst September in 20 years) was “impressive” indeed.

“Given how bad this year has been, that wasn’t an easy call when we doubled down on our bearish view for stocks four weeks ago,” he said.

Wilson has, of course, maintained a bearish stance on equities for the better part of a year. It’s been the right call.

On Sunday, he highlighted the Bank of England’s emergency intervention, noting that although the BoE’s decision to “temporarily” support long-dated gilts was aimed at rescuing pension funds and preserving market functioning, investors would be remiss not to consider the broader implications.

“With pain this severe in certain markets, some of the cavalry has been called in,” Wilson said. “Some may argue the UK is in a unique situation and so this doesn’t portend other central banks doing the same thing [but] this is how it starts.” The emphasis was in Wilson’s original note.

This is a very slippery slope. As discussed at some length here over the weekend, there’s no guarantee the BoE will be able to sell the bonds they’re buying without impacting markets, let alone sell the newly-purchased long-dated gilts and commence QT, as originally planned prior to last week’s meltdown.

Markets have already snapped. I summed it up in “Neon Swans, Cash And A Dubious Anniversary.” The question is no longer “How long until something breaks?” Something broke last week. It was the UK bond market. And before that it was the yen. The yuan is still breaking. So is the euro. Soon enough, it’ll be credit. As such, the question is “How long before the crescendoing panic is too loud for the Fed to ignore?”

Wilson agrees. “Investors can’t be as adamant that the Fed will choose to or be able to follow through on its guidance,” he said. “Like it or not, the world is still dependent on US dollars, which provide the oxygen for global economies and markets.”

Fed officials were keen last week to suggest that overseas tumult doesn’t have immediate implications for US monetary policy, but that contention doesn’t work the other way around. Big shifts in US monetary policy always have implications for the rest of the world. Immediately.

Wilson reminded investors that the bank’s mid-cycle transition call in March of 2021 was predicated on peaking M2 growth. As it turns out, that was “exactly when the most speculative assets in the marketplace peaked and began to suffer,” he said, citing crypto, SPACs, IPOs and profitless growth shares. March of 2021 was also “peak Cathie Wood,” so to speak.

Fast forward 18 months and Wilson warned M2 growth is in the “danger zone,” a precarious tipping point beyond which “financial/economic accidents tend to occur.”

The figure above suggests M2 in dollars for the world’s four largest economies is falling on a YoY basis for the first time in more than seven years, and is projected to fall rapidly going forward. That, Wilson wrote, doesn’t bode well for stocks.

Wilson called the current tightening “unsustainable.” If it continues, it will “lead to intolerable economic and financial stress,” he cautioned, citing last week’s turmoil as an example. Although he conceded that Liz Truss’s fiscal unveil was widely viewed as the proximate cause of the meltdown, Wilson suggested “the reaction in financial markets was so extreme due to the tightening of liquidity in the global system.”

The good news is, the Fed can fix the situation with a keystroke. “US dollar supply is tight for many reasons beyond Fed policy, but only the Fed can print the dollars necessary to fix the problem,” he said.

With that in mind, Wilson posed two related questions. First, he asked when the problems the strong dollar is creating for the rest of the world will boomerang and make landfall in the US. Although it’s impossible to say with anything like certainty, Wilson sounded sure of one thing. “More price action of the kind we’ve been experiencing will eventually get the Fed to back off,” he wrote.

Then, he asked whether the Fed, once it decides enough is enough, will be able to rescue the world simply by dialing back or ending QT, or whether Jerome Powell will ultimately be compelled to restart asset purchases. In Morgan Stanley’s opinion (or at least in the opinion of the bank’s US equities team), a sustainable rally in US stocks requires the resumption of QE.

And yet, the die is cast for earnings. The profit reckoning that was kicked down the road in Q2 is likely to “realize” in Q3, with attendant guide downs and revisions, especially given the lagged impact of the stronger dollar on multinationals. It’s too late for the Fed to prevent an earnings recessions, or something that feels a lot like one.

The bottom line for Wilson is that without a Fed pivot, stocks are probably going lower. If, on the other hand, the Fed does pivot or the market becomes convinced a pivot is imminent, a “sharp” rally could ensue at some point.

He closed with a flourish: “Just keep in mind that the light at the end of the tunnel you might see if that happens is actually the freight train of the oncoming earnings recession that the Fed cannot stop.”

Duly noted.