Three Stories For 2023’s Everything Rally

There are three stories driving the market in 2023 and those stories are “distinctly different.”

That’s according to Morgan Stanley’s Andrew Sheets, who noted that in stark contrast to 2022, almost everything is up so far this year. “It’s been one of the strongest starts to a year in recent memory,” he said.

Remember: US Treasurys were almost guaranteed to rise this year. 10-year US government bonds (or their equivalent) haven’t suffered three consecutive years of losses in the (admittedly short) history of America’s republic. And although the S&P 500 has notched consecutive annual declines on multiple occasions, such cases are nevertheless rare.

Whether the “everything rally” continues depends in no small part on the viability of the stories driving it.

The first story is China’s re-opening. I’m skeptical. Not about the re-opening, necessarily. That’s pretty straightforward. Some sort of herd immunity will develop if it hasn’t already and barring some new, more deadly strain of the virus (which would presumably affect all nations, not just China), Xi will keep the economy open, and growth will recover from last year’s anemic (for China) ~3% pace.

The bigger questions surrounding the world’s second-largest economy are about i) Xi’s willingness to let the private sector flourish such that the economy can stay vibrant as the country continues to transition from a smokestack, industrial model to a more modern, consumer-driven setup, and ii) if and how the geopolitical tensions between Beijing and Washington are resolved. Currently, the US is shooting surveillance balloons out of the sky with fighter jets and China is logging official protestations and making the usual veiled threats about reserving the right to “protect its interests.” That’s pretty inauspicious.

From a “pure” markets perspective, Morgan’s Sheets said one counterpoint to the China optimism story is that hedge funds have already increased their exposure, but in the bank’s view, the bottom line is that investors are “seeing a major policy shift in a very large economy, impacting markets that trade at reasonable valuations.”

While it’s true that the MSCI Asia is technically in a bull market, it’s flat versus five years ago.

The second story is, of course, Europe and the bloc’s miraculous economic performance in the face of an unprecedented energy shock. “A warm winter and sizable US imports have raised the once unimaginable prospect that Europe may have to deal with too much natural gas relative to what storage can hold,” Sheets remarked.

As a result of the averted crisis, Europe is “investable” again for corporates, he went on, adding that inflows into regional shares have surged. I’d suggest “surged” might be too strong if we’re talking specifically about equity funds. According to EPFR’s data, European stock funds have indeed seen a dramatic turning of the proverbial tide, but the total amount of inflows in 2023 (just over $3 billion) isn’t exactly a tsunami in an absolute sense.

The third story is the US, and specifically the “immaculate disinflation” narrative. “That’s one way to explain higher equities, lower yields, tighter spreads and expectations that the Fed funds rate is 150bps lower” by year-end, Sheets wrote, of the market’s new theme du jour+. A soft landing is, in fact, Morgan Stanley’s house view.

But there are two other explanations for Wall Street’s galloping start to 2023. One centers on the notion that earnings will stay resilient, but suffice to say the bank’s Mike Wilson is skeptical of that. The other is about flows, cash that sat on the sidelines in 2022 which now “needs” deploying and a “force-in” dynamic as under-positioned funds chase stocks higher.

You could easily argue that the positioning/flows story is the most compelling when it comes to explaining recent price action, but if that’s true, Sheets wonders if it’s sustainable. “If positioning is the story, can it persist?” he asked.

“The equity momentum factor has already reversed all of its gains since January 2022 in both the US and Europe [and] our sentiment indicators suggest that conditions have moved from fearful to complacent,” Sheets continued, adding that “cash has so far largely stayed on the sidelines,” which he gently suggested might be due to the fact that “those ‘sidelines’ pay pretty well given high money market yields.”