Finally, a Wall Street strategist that is making perfect sense. Michael Wilson at Morgan Stanley:
The market appears ready to take on a more defensive character as we experience a meaningful deceleration in earnings and economic growth. Inventory builds are unlikely to offset if order books prove to be inflated as we suspect.
Our mid-cycle transition narrative has been playing out nicely since mid-March, with small caps and lower-quality stocks underperforming consistently. Quality can mean a lot of things and for many it simply means large cap growth win. While many of these stocks fit the high-quality bill, we think the quality rotation will now begin to favor more defensive properties like earnings stability rather than growth.
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UpgradingStaples/Downgrading Materials. Consumer Staples are the epitome of boring, but boring can be beautiful if the broader market begins to falter. We are upgrading today as the relative earnings revision bread this just starting to turn up. This inflection higher will be driven more by revision breadth for the S&P500 decelerating. The market should start to pay up for earnings stability.
Materials are the opposite as they are highly levered to the early cycle part of the recovery and inflection higher in commodity prices, which now look vulnerable to a correction as we get a payback on demand from last year’s overconsumption.
We still prefer Software over Semis, and Healthcare over Tech. What is the Bad Breadth in the market foreshadowing? Market breadth has been deteriorating for months and is just another confirmation of the mid-cycle transition, in our view. It usually ends with a material(10-20%) index level correction. More specifically, we think it is foreshadowing a significant growth deceleration in earnings and the economy that may feel worse than most are expecting.
Quality with a Defensive Twist Since March we have been calling for a mid-cycle transition. What this means in economic parlance is that we were approaching the peak rate of change in policy and growth, and that usually coincides with important equity market leadership changes. More specifically,early-cycle stocks begin to fade along with those stocks that may struggle to execute as supply/demand imbalances appear. Given the speed and severity of this cycle was particularly acute, we recommended a quality bias and downgraded small caps. The pair has worked well (Exhibit1) and now begs the question, has it run too far? Afterall, we’re simply going through a mid-cycle transition, not the end of the cycle.
While we do think the recent leg higher has been extreme, we think quality can continue to lead, particularly quality with defensive, rather than growth, characteristics. In short, that means Healthcare, Staples, REITs, Telcos andpossibly Utilities rather than just Tech. On that note, Tech’s performance has been narrowing toward the higher-quality large cap FAANG stocks rather than unprofitable, go-go growth names, a reflection of this defensive rotation.
In line with our more defensive quality skew, we are upgrading Consumer Staples to overweight and downgrading Materials to neutral. We upgraded Staples to neutral in April and relative performance has flattened out after a year of significant underperformance. Now, we think the sector is poised to outperform as the broader market gets more defensive and the Sector’s relative earnings revision breadth turns up(Exhibit2). On Materials, it’s the opposite. The sector has been a strong outperformer as it typically is during the early-cycle recovery phase. However, as we move to mid-cycle, that performance tends to fade, and it already has to some degree. Meanwhile, relative earnings revisions may have peaked in May (Exhibit3). While we remain positive on the reflation story for this cycle and regard materials as a good way to play it, we also acknowledge the stocks have discounted a good chunk of that story and now look vulnerable. Furthermore, China’s slowdown and recent dumping of some materials presents a headwind in the short term. Finally, our payback in demand thesis for the next several quarters is likely to weigh on the more cyclical parts of the market.
Our present tilt fits this perfectly, running a barbell of quality defensive with quality growth vis FAAMGS.