Mike Wilson on Fed, Inflation, Artificial Intelligence

Summary

Traders are closely monitoring the upcoming Consumer Price Index (CPI) report for clues on whether the Federal Reserve will cut interest rates next week. Concerns persist over whether the Fed has been too slow in addressing economic issues. Analysts like Mike Wilson of Morgan Stanley suggest that either aggressive Fed cuts or improved labor market data could help boost equity markets. The conversation also covers inflation, currency risks, the bond market, and potential impacts on the stock market. The upcoming US election's effect on earnings and tax policies is also discussed, particularly how Trump's and Harris' proposals could shape economic growth.

Takeaways

• 🕒 Traders are anticipating the Consumer Price Index (CPI) release at 8:30 AM Eastern time for indications on the Federal Reserve's rate cut decisions next week.
• 🤔 There's ongoing concern that the central bank might have delayed its actions, potentially impacting the effectiveness of future monetary policy adjustments.
• 💼 Mike Wilson from Morgan Stanley suggests that equity markets are struggling due to the bond market's skepticism about the Fed's ability to catch up with the economic curve.
• 📉 The bond market is seen as a reliable predictor of the Fed's stance, with the yield curve's behavior often reflecting market expectations about economic growth.
• 📈 The stock market has shifted its focus from quality growth stocks to quality defensive stocks, indicating a late-cycle behavior and a cautious market stance.
• 📉 Labor Day sales have been disappointing, adding to the negative growth data trends observed since April, which the equity market has responded to by pivoting towards defensive stocks.
• 💹 The market is awaiting clear signals on whether the Fed will cut rates aggressively or if there will be a quick improvement in the labor market to support equity performance.
• 💵 Mike Wilson believes that inflation, in terms of rate of change, is no longer a significant concern for equity markets, but the price level continues to exert pressure on businesses and consumers.
• 🌐 The Fed is in a challenging position, needing to balance the yen-dollar relationship and the potential stress that aggressive rate cuts could cause in currency markets.
• 📊 The market's reaction to the CPI data release will be crucial, with a higher-than-expected number potentially signaling that the Fed is lagging behind, and a lower number suggesting that the economy might be slowing faster than anticipated.

Q & A

What are traders waiting for in this transcript?

Traders are awaiting the Consumer Price Index (CPI) data at 8:30 Eastern time for clues on how the Federal Reserve will act regarding rate cuts.

What concerns are being raised about the Federal Reserve's actions?

There are concerns that the Federal Reserve may have waited too long to address economic conditions, as growth data remains disappointing.

What does Mike Wilson of Morgan Stanley suggest in his writing?

Mike Wilson suggests that equity markets will struggle to trade with a more 'risk-on' tone unless the bond market believes the Fed is no longer behind the curve, growth data improves significantly, or additional policy stimulus is introduced.

Why does the bond market matter in this context?

The bond market is historically a good indicator of where the Fed stands relative to its actions. It influences how markets interpret the Fed's next steps and signals broader economic expectations.

What is meant by 'quality growth' and 'quality defensives' in this discussion?

'Quality growth' refers to stocks with strong growth potential, while 'quality defensives' are traditionally stable sectors like utilities, staples, and healthcare. These defensive stocks perform well in late economic cycles when growth data is weak.

How might a hot CPI print affect the stock market?

A hot CPI print could be bad for the stock market as it might indicate that inflation remains persistent, which would lead the Fed to maintain a more aggressive stance on rates, further stressing market conditions.

What could happen if the Federal Reserve starts cutting rates aggressively?

Aggressive rate cuts by the Fed could negatively affect the currency market, particularly the yen-dollar relationship. It may also reduce the chances of a soft landing, historically decreasing the likelihood of economic stability.

What is the market looking for as a new theme after AI hype cooled down?

After the AI theme became overextended, the market is now looking for a new growth narrative. Until that emerges, investors are retreating into high-quality defensive assets.

Why is inflation not completely over despite lower rates of change?

While the rate of change in inflation has stabilized, the overall price level remains high, squeezing businesses and consumers. This ongoing pressure means inflation is still a significant economic concern.

How do taxes influence stock and bond markets under different political administrations?

Lower taxes, like those proposed by Trump, are seen as pro-growth and beneficial for stocks but can negatively impact bonds. Conversely, higher taxes, like those proposed by Harris, would benefit bonds but be negative for stocks.

Outlines

00:00

📈 Market Expectations and Fed's Dilemma

The first paragraph discusses the anticipation of the Consumer Price Index (CPI) release, which is crucial for gauging the Federal Reserve's potential rate cut decisions. Traders are concerned about the Fed's timing and whether it might be too late. Mike Wilson from Morgan Stanley suggests that equity markets are struggling due to the bond market's skepticism about the Fed's actions. The conversation highlights the importance of the difference between Fed funds and the yield curve, particularly the two-year rate, as an indicator of the Fed's stance. The bond market is seen as a reliable predictor of economic conditions, and the current situation points to continued growth disappointments. The stock market is shifting from quality growth to quality defensive stocks, reflecting late-cycle behavior. The discussion also touches on the challenges the Fed faces, such as currency market stress if they cut rates aggressively, and the historical implications of starting a cutting cycle with larger increments.

05:03

📉 Inflation Outlook and Market Reactions

The second paragraph delves into the concept of inflation and its impact on the market. The speaker asserts that while the rate of change in inflation might be over, the price level continues to exert pressure on businesses and consumers. The discussion anticipates potential market reactions to CPI data, suggesting that a higher-than-expected number could be detrimental to stocks, as it would imply the Fed is lagging behind the curve. Conversely, a lower number might indicate a loss of pricing power, typically unfavorable for stocks. The speaker also speculates on the Fed's upcoming actions, including the possibility of a 25 basis point rate cut and the management of the balance sheet. The conversation shifts to the potential impact of the US election on earnings growth, with different tax proposals from the candidates potentially influencing market performance. The speaker concludes by cautioning about the defensive nature of the utility sector, suggesting that its performance could be an indicator of a potential hard landing for the economy.

Keywords

💡CPI (Consumer Price Index)

The CPI is an economic indicator that measures changes in the price level of a basket of consumer goods and services. In the script, traders are awaiting CPI data for insights on inflation trends and its potential influence on the Federal Reserve’s decision regarding interest rate cuts.

💡Federal Reserve (Fed)

The Federal Reserve is the central bank of the United States responsible for monetary policy. In the video, discussions focus on how the Fed may react to economic data, particularly inflation and labor market conditions, by adjusting interest rates to stabilize the economy.

💡Interest Rate Cuts

Interest rate cuts refer to the Fed lowering its benchmark rates to stimulate economic activity. The script discusses market expectations surrounding whether the Fed will cut rates in response to economic challenges and inflation concerns.

💡Bond Market

The bond market is where debt securities are issued and traded. It acts as a significant indicator for Fed policy decisions. In the script, the bond market's response to interest rates and economic growth is considered a signal of future economic conditions.

💡Yield Curve

The yield curve shows the relationship between interest rates of bonds with different maturities. An inverted yield curve is often a warning of a potential recession. In the script, the Fed funds rate and the front end of the yield curve are mentioned as important indicators of market expectations.

💡Quality Growth

Quality growth refers to stocks that exhibit consistent earnings growth. The script highlights a shift from quality growth stocks to defensive stocks, which is typical of late-cycle market behavior as investors become cautious about economic uncertainty.

💡Defensive Stocks

Defensive stocks are shares in companies that provide consistent dividends and stable earnings regardless of the state of the economy, such as utilities and healthcare. The script discusses how the market is pivoting toward defensive stocks due to concerns about growth and economic stability.

💡Soft Landing

A soft landing refers to a situation where the Fed successfully slows down the economy to curb inflation without triggering a recession. The speaker in the video expresses hopes for a soft landing but acknowledges the challenges, particularly in relation to interest rate decisions.

💡Currency Market

The currency market, or forex market, is where currencies are traded. In the script, the relationship between the yen and the dollar is highlighted as a concern for the Fed, since aggressive rate cuts could affect currency exchange rates and introduce financial instability.

💡Inflation

Inflation is the rate at which prices for goods and services increase. In the script, inflation is discussed in two contexts: the rate of inflation, which is seen as under control, and the price level, which continues to affect businesses and consumers, creating pressure despite reduced inflation growth.

Highlights

Traders are awaiting CPI data at 8:30 AM Eastern time for clues on potential Federal Reserve rate cuts.

Concerns remain about whether the Federal Reserve has waited too long to act on rate cuts.

Mike Wilson from Morgan Stanley suggests that the bond market needs to believe the Fed is no longer 'behind the curve' for equity markets to improve.

The bond market serves as a strong indicator of whether the Federal Reserve is where it needs to be in terms of policy.

The defensive stocks in the market are performing well, signaling potential economic caution.

Growth data has been underperforming since April, and the labor market has worsened significantly.

Equity markets have shifted from 'quality growth' stocks to 'quality defensives,' which is a classic late-cycle behavior.

The Fed is constrained not by inflation but by the currency market, specifically the yen-dollar relationship.

Cutting rates by 50 basis points, instead of 25, significantly increases the risk of a 'hard landing.'

The market is not as concerned with the next Fed move but rather how the markets will react after the Fed's decision.

Defensive sectors include utilities, staples, and healthcare, which are positively correlated to bonds.

The AI theme in the market has cooled down, with semiconductor stocks declining.

Inflation is considered 'over' in terms of rate of change, but price levels continue to squeeze businesses and consumers.

A hot CPI number would be bad for the stock market, reinforcing the idea that the Fed is behind the curve.

Utilities are trading well due to their defensive properties, but their balance sheets are a concern if a hard landing occurs.

Transcripts

Traders awaiting CPI at 830 Eastern time for clues about how much the Fed will

cut rates this time next week. Concerns are lingering over whether the

central bank has waited too long. Mike Wilson of Morgan Stanley writing

Until the bond market starts to believe the Fed is no longer behind the curve,

growth data reverses course and improves materially, or additional policy

stimulus is introduced. It will be difficult for equity markets

to trade with a more risk on tone. Markets with this around a table might

commodity asset. Good morning.

How are you? I want to pick up on that quote and

we're doing great. I want to pick up on a line that you're

focused on. The difference between Fed funds and the

front end of the yield curve Fed funds in a two year and that quote.

How important is that? Well, that's a signal that we're getting

from the bond market. Bond market has historically been a

pretty good indicator of where the Fed is relative to kind of where they need

to be doing. And we saw this, by the way, in the

upside to rate in the 2021 timeframe, the two year.

Got ahead on the upside. So it's the same picture just on the

other side and and people's complaint oh they don't complain they say we look at

the stock market is is behaving fine but that's not true internally.

Once again you know defensive stocks are really doing extremely well.

So I think the the stock market's taking its cues from what the bond market is

saying. It's not saying hard landing yet.

What it's saying is that growth is continued to disappoint.

So since April and we've been on this program many times since then, I would

say that the data has been under distinguish distinguished negative in

terms of growth data. Also, the Labor Day has been much worse.

So how has the equity market dealt with that?

Well, it's pivoted from what I call quality growth to quality defensives.

And we made that pivot in May, and that's classic late cycle behavior.

So I think everything kind of sinks. It's just we're waiting for the, you

know, can somebody give us the keys to the test, you know, the Cliff notes,

whatever it is, and how is this going to end?

And we don't know. But the markets you don't get I'm going

to ask it. Basically, you've said we need one or

two things. Either the Fed cuts aggressively or the

labor market starts to improve and improve quickly.

That's right. For equity markets to perform well.

So if you've got a base case, is it one of the other two?

We get one or the other? Well, what I would say is that the Fed

could get ahead of the curve if they decide.

But the problem, they're constrained, okay?

They're constrained by two things, not inflation.

By the way, inflation's over as far as I'm concerned.

Inflation. They beat that.

What what the issue is now is the currency market.

If they come in and start cutting aggressively, the yen dollar

relationship is going to create some stress.

So they need to be careful with that. The other thing I would throw out there

is that we've looked at this when the Fed starts a cutting cycle with 50 basis

points as opposed to 25, the chance of a soft landing goes down materially.

And they noticed they know this data. They don't want to signal that.

So they're they're in a tough spot. The Fed's in a difficult spot.

They've done a they've done a, you know, a good job of trying to navigate this,

you know, challenging different environment that we've been in for the

last several years. But now the markets are pressing them.

And so next week, I don't really care what they do next week.

What I care about is how the markets react, how the markets behave after

they've done what they're going to do. 25 probably.

And then what did they say in the press conference, the vibes, whether they

actually work for the market or not. I'm curious, though, before we go into

quality growth and quality defensive and what that actually means, you said

something about the currency differential.

Are there certain target levels that you see sort of unwinding some of the longs

that still remain out there? Do you have a sense of just how

disruptive the ongoing long trade for the dollar really will be potentially

down the road? Yeah, I mean, I don't have a specific

level, but I do feel like they're trying to defend this low one forties level

between each dollar. So call 142 if we start to you know, 130

ish, 138 139 I think that could cause some stress in other markets.

Meanwhile, you talk about shifting from quality growth to quality defensive.

I've struggled with these monikers quite a bit simply because what does

defensive, what does growth mean? Where does invidious fit into this or

does the tech trade go given the fact that people have gotten an I traded so

inflated in terms of expectations and in timing, what does that mean to you?

Quality defensive? You know, defensives are your classic

defensive sectors, whether it's utilities, staples, healthcare, things

that are positively correlated to bonds. They and they did not trade well by the

way, up until sort of April. It was really the quality growth stocks.

Now, the other thing that's happened is the I dream has taken a little bit that

luster has come off. And I really gauge that by what

semiconductors are doing. It's not just really it's it's

semiconductors writ large. And a lot of those stocks have really

come off. And that makes sense to me.

We just we just get overcooked. And the whole AI theme doesn't mean it's

over. We've written about this extensively,

like we're not believers, that this is going to change productivity materially

in the short term. It's a long term story and everything

kind of got beat up on that. So with that that theme now gone, the

market is looking for a new theme. On the growth side, there isn't one.

So when it does, it hunkers down into defensive, high quality assets until we

get the next thing. Whether that's a bad outcome or or a

positive outcome, they're going to hide out in these areas.

Mike, you say inflation is over. We do have CPI data though, today, so

I'm curious to know how do you think the market would trade if we get, say, a

hotter print? Is it too volatile or softer with the

markets that pricing in 50 or look at a softer print and say, wow, we are

cooling down faster than even the Fed was expecting and bad news really is bad

news? Yeah, well, when I said inflation is

over, I mean, the rate of change on inflation is over and it's kind of over

for equity markets and quite frankly, ever for the Fed, where inflation is not

over is the price level. Right.

The price level is absolutely squeezing the heck out of businesses and

consumers. And so it's like a vise.

And so I don't think inflation is over in that regard.

But what I would say is that, you know, a hot number, I think is probably pretty

bad for the stock market today. I'm expecting that.

But if we get a hot number today, then all of a sudden the Fed is going to stay

behind the curve. They're kind of stuck.

If we get if we get a really soft number, then we go back to our old

thesis, which is pricing power is gone. Okay.

So we kind of need to thread the needle here a little bit too.

I mean, break evens are at 2% now breaking.

So what are we talking about? We're already at 2%.

And it's not like these things stop on a dime.

They have a you know, there's a risk that we undershoot on the downside

that's good for bonds and is bad for stocks typically.

And by the way, that's how the stock market, that's how the markets are

trading. So I think I think the markets are you

understand all of this. Once again, they're going to do

something next week to try and, you know, manage the situation in 25 is what

we think. And they'll signal for more 25, not 50.

And then what do they do with the balance sheet?

I think that's probably the bigger wildcard.

Do they do they talk more aggressively about ending cut or quickly?

Do they find other other provisions to provide liquidity?

That's the bull case, in my view. That's where we could be surprised in

the upside. Is there more liquidity coming into the

system from other sources? And after next week, then everyone's

going to really be focused on the US election, Goldman Sachs RBC, they talk

about how earnings will be much higher potentially under a Trump administration

if he gets his tax cut plan rather than Harris, who's calling for 28%.

How do you view next year earnings growth based on these two proposals,

assuming that the economy is in a soft landing, okay, that the Fed hasn't

overstayed its welcome? And by the way, I think that risk is

still on the table. We're in the soft landing camp, but it's

that to me is way more important than the outcome in this election in the next

6 to 12 months. So let's assume we're in a soft landing.

Our views are saying we think that basically Trump is kind of pro-growth,

kind of bad for bonds, good for stocks. Okay.

And that's how we would look at it. And by the way, last night when the

debate was going on, the betting markets kind of went in favor of Harris and the

stock market futures kind of traded a little bit.

Okay. But I do think the stock market is

pro-Trump. I mean, the stock market has traded

better when his odds go up and vice versa.

So bonds are good under. Harris and stocks are bad under Harris.

In theory. I mean, at the margin, I would say

that's the setup. And the reason being is is really taxes.

Taxes is the one thing that requires some congressional support, too.

But to me, that's the big issue, not tariffs so much.

Both administrations have tariffs and immigration.

I think both parties are going to deal with that in some way.

So taxes is the issue. Obviously, Trump is talking about

cutting. Harris is talking about raising them.

That's bad for stocks, good for bonds. I wanted to ask you this question.

I want to squeeze it in. At the very end, Lisa was knocking on

the door. A utility's actually defensive.

They're up like 20% this year and it feels like everyone's getting whatever

they want from utilities. It's defensive.

It's so attached to what are utilities. So this is a very interesting question.

So, you know, we agree. I mean, we we don't think we were one of

the first ones to talk about utilities as an AI beneficiary back in February,

March. I think that's probably getting a little

over done to be to be honest. But now utilities are definitely trading

with the bond market, so they are the defensive properties of utilities are, I

think, dominating their performance in the near term.

Here's the here's the interesting about utilities.

Their balance sheets are typically are not great.

Okay. So you got to be really careful with

utilities if it's going to be a hard landing.

These things are going to start trading really poorly.

So I would caution listeners, if utilities start trading really poorly

and the stock market is not ripping, that's a bad sign.

That would be a sign that, oh, we are actually getting closer to potentially

hard landing risk. That's hasn't happened yet.

But if you look at things like low volatility, parts of the of the stock

market or defensive, they've gone almost parabolic.

And if they start to sell off hard without a stock market rally, then I get

concerned about hard landing risk. That's not the case today.