Morgan Stabley bearing it up:
Over the past few weeks, we’ve been spending a lot of time with investors discussing and debating our mid-year outlook. Here are the highlights:
First,investors are definitely more receptive to the mid-cycle transition narrative that we introduced a few months ago. There’s an acknowledgement that something has changed in the market, because more investors are struggling to make money consistently as leadership flip-flops day to day. This is consistent with the typical mid-cycle transition as the market struggles to find the next consensus trade.
Second, while investors are warming up to our mid-cycle transition thesis, they don’t agree that USequity valuations need to fall by another 15%, as we suggest. Though this view is based on historical mid-cycle transitions, many we speak with think that this time is different because the Fed and other central banks are committed to staying dovish for longer than normal. We don’t doubt the Fed’s resolve but believe that a more dovish Fed today means it will need to tighten faster later. We also think the equity market understands this and will discount it by proactively taking valuations lower through the equity risk premium channel, rather than waiting for cues from the bond market. More importantly, it’s already happened in the most expensive and lower-quality parts of the equity market, and we think this de-rating will eventually reach the S&P500 (Exhibit1).
Third, many investors believe we are too conservative on earnings growth for next year. Since we were the first to call for a V-shaped recovery and extraordinary operating leverage last year, we’re taking this particular pushback with a grain of salt. Instead, we remain concerned that after the most positive earnings revisions quarter on record, next year’s consensus forecasts are now above what our analysis suggests is achievable for the first time since the recovery began. More specifically, we think margin assumptions are too high given headwinds from inflation and taxes that have not been baked into estimates. The market should start to factor them in via lower valuations.
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Fourth, many of our favored trades are also receiving pushback. To start with our downgrade of industrials, many investors ask, why now given the push for greater infrastructure spending? We think much of this spending has been appropriately priced and such projects generally take much longer to come to fruition than the majority of investors appreciate. Furthermore, many industrial companies will suffer the most from the developing inflationary headwinds in supply chains and labor shortages. Instead, we continue to prefer financials and materials stocks as ways to capture rising inflation while avoiding reopening risks. Although our preference for healthcare over technology is also out of favor, we sense that investors are looking more actively at healthcare for new ideas. Our preference stems from cheaper valuations and greater pent-up demand for healthcare services than technology goods, where there is a risk of payback from last year’s surge.
Finally, the greatest pushback continues to be on our call for consumer staples to do better than consumer discretionary stocks in the mid-cycle transition. Here,investors believe excess savings will translate into better-than-expected growth for consumer discretionary businesses. However,our analysis suggests that overconsumption last year relative to longer-term trends will curtail some of this spending as the economy reopens. In addition, consumer discretionary stocks are classic early-cycle winners and tend to underperform in the mid-cycle stage.
Bottom line, we’re out of consensus with our mid-cycle transition call. The fact that it’s receiving a healthy amount of pushback is a good sign it’s not yet discounted. This suggests that further consolidation or an outright correction in the S&P500 is likely, and the best way to make money will be via relative value trades. Our favorites remain staples over discretionary, healthcare over tech, and materials over industrials. We also continue to favor banks as the best way to play inflation and recommend avoiding early-cycle plays like semiconductors, many retailers, and homebuilders/improvement stocks. Finally, moving up the quality curve remains a good strategy across one’s entire portfolio, with the caveat that you can’t overpay for it–i.e., look for quality at a reasonable price.
What is so interesting about this analysis is that I am sympathetic to it but for completely different reasons.
MS sees reflation pressuring margins and stocks falling away as their mid-cycle base case. Whereas I see a one-off inventory supercycle and commodities bubble driving an inflation head fake that is going to unravel in the months ahead as China slows sharply.
So, corporate margins are actually going to improve as supply-side and commodity price inflation collapses. In addition, as US inflation deflates, putative Fed tightening will be pushed out.
But I also have a strong (and rising) risk case that shares weird similarities with the MS scenario. It is that the China slowdown converges with the US fiscal cliff in and around Q4 this year and the inventory super-cycle plus commodity deflation mutate quickly into an outright growth shock for richly valued markets.
If central banks have moved too far in advance of it then it will be even worse.
So, I also see a mid-cycle transition with the possibility of a major correction. But one that is driven by deflation not inflation. So the portfolio allocations are different:
- Agree on consumer staples over discretionary.
- Agree on quality.
- Disagree on quality tech which will do well if yields fall. Healthcare could still be good, though, as will be utilities, telcos, REITS and other yield stocks.
- Totally disagree on materials. That’s danger meeting danger! Banks are seriously overvalued and vulnerable.
What I find with just about all of this Wall St analysis is that it is far too US-centric. Ignore China at your peril.
To be clear, I see this playing out over 12-18 months. After that, the US labour market will start to benefit directly from the Biden stimulus and US inflation grind higher again with a higher DXY.
Whether the rest of the world can follow it will be the emerging problem of the cycle as China keeps on slowing which raises the prospect of an EM crash a few years out.