Unexpected fiscal largesse.

That’s one, but not the only, reason Morgan Stanley’s house call on US equities was wrong in 2023.

So said the bank’s Mike Wilson, who was keen to remind investors that he was on the right side of fiscal dominance with his equity call for the better part of two years.

“First, the Fed had to be overly supportive and help to fund the near-record deficits in 2020-21; then it had to react with historically tighter policy once inflation became too elevated,” he wrote, going back to the not-so-distant future.

Wilson was overtly bullish on stocks in 2020. Shortly thereafter, Morgan Stanley’s strategists said economic and earnings cycles were likely to be more dramatic and shorter-lived, at least in the near-term, in part because the Fed would find its hands tied and be unable to take steps to prolong the expansion. It’d be critical, Morgan Stanley began to suggest in 2021, for investors to appreciate the “hotter but shorter” cycle dynamic and incorporate it into their strategy. Wilson was on the right side of it — right up until 2023.

“Part of the reason we’ve found ourselves offside this year is that the fiscal impulse returned with a vengeance and remained quite strong — something we didn’t factor into our forecasts,” he said.

He pointed to the visual above. “We have rarely ever seen such large deficits when the unemployment rate is so low,” he wrote. Then, he posed a question: “If fiscal policy is showing such little constraint in good times, what happens to the deficit when the next recession arrives?”

I think we all know the answer to that, and history generally shows that neither party in America’s political duopoly actually cares about fiscal discipline. The only difference between the two is the preferred method for accumulating red ink — Republicans like supply-side “reforms,” Democrats (rightly, in my opinion) prefer to take a less circuitous route that doesn’t rely on trickle-down dynamics that’ve demonstrated a “surprising” penchant for malfunction over the years.

So, is Wilson ready to throw in the towel on his cautious equity view? In a word: “No.” In two: “Not really.” In three: “No, not really.”

“The main takeaway for the equity market this year is that fiscal policy has allowed the economy to grow faster than forecast, giving rise to the consensus view that the risk of a recession has faded considerably,” he went on, noting that the suspension of the debt ceiling out to 2025 ostensibly opens the door to more fiscal generosity. Note that GOP opposition to fiscal stimulus would almost surely fall away were a Republican to retake the White House.

The biggest non-distributional criticism (i.e., criticism not related to the notion that corporates and the rich benefited disproportionately) of Donald Trump’s fiscal policies revolved around the idea that he was pursuing expensive stimulus for the sake of it — largesse in the name of America’s economic vanity. The economy was doing fine. There was no obvious need for fiscal stimulus. But he pursued it anyway. The point: Fiscal largesse is a bipartisan “problem.”

Wilson said the Fitch downgrade points to the “limits” of pursuing such a policy bent. I doubt it. Not when the likes of Jamie Dimon and Warren Buffett are telling the public to ignore the ratings agencies. And not when Treasurys remain the preferred (and in many contexts the only viable) savings vehicle for recycled export proceeds. And not as long as US paper, notes and bonds are the collateral that makes the Earth spin.

It is possible, though, that supply jitters exacerbated by cautionary remarks from ratings agencies could drive up yields, imperiling an equity rally built on valuation expansion. Last week’s bond market theatrics were defined by a rise in reals, and rising reals are kryptonite to stretched equity multiples.

“Bond markets have sold off considerably. This should start to call into question equity valuations,” Wilson warned. “Furthermore, if fiscal spending must be curtailed due to higher political or funding costs, the unfinished earnings decline that began last year is more likely to resume, as we continue to forecast.”