Morgan Stanley's Wilson on Stocks, Fed, Inflation

Summary

The video script discusses the recent market correction and its causes, including equity market shocks and carry trade unwinds. It suggests that consumer spending is slowing down, affecting both goods and services companies. The script highlights the challenges of market recovery due to slowing growth and high earnings expectations. It also touches on the Federal Reserve's cautious approach to rate cuts and the potential impact on consumer sentiment. The discussion emphasizes the importance of defensive strategies and the risks associated with high market valuations and leverage.

Takeaways

• 📉 The market correction was unexpected and has occurred immediately, with various reasons contributing to the situation.
• 🔄 The speaker anticipates a period of stagnation within a certain market range due to recent events.
• 💹 There was a significant shock beyond the equity market correction, including the unwinding of carry trades, causing discomfort among some investors.
• 🛑 The consumer slowdown is a key concern, affecting not only goods companies but also consumer services, which needs to be addressed.
• 📈 For markets to reach new highs, multiple expansion is necessary, which is challenging in a slowing growth environment with high earnings expectations.
• 🤔 The Federal Reserve's reluctance to be proactive and its data-dependent approach is criticized but also defended as a responsible reaction.
• 🗓 The possibility of a rate cut in September is mentioned, but its impact on consumer behavior is not expected to be immediate.
• 🏠 The housing market is specifically discussed, with the suggestion that a modest rate cut will not significantly affect consumer sentiment or stock performance.
• 📊 There is a focus on stock-level analysis and second-level trades due to the inappropriate market valuation, with a fair market multiple suggested to be around 19 times earnings in a soft landing scenario.
• 📉 High levels of equity leverage in the system are a concern, with the potential for further market shocks if not addressed.
• 📊 Earnings expectations for the second half of the year are expected to be weaker, with tough comparisons from the previous year and a possible lack of order book growth.
• 📉 The connection between inflation expectations and stock performance is highlighted, with lower inflation potentially being bad news for stocks due to reduced pricing power.

Q & A

What is the general view on the recent market correction?

The general view is that the market will likely be stuck in a range after the recent correction, partly due to the big shock not only in equity markets but also in the carry trade.

Why might it be challenging for markets to reach new highs?

It could be challenging for markets to reach new highs because growth is slowing, earnings expectations might still be too high, and the Federal Reserve is reluctant to be proactive.

What is the speaker's perspective on the Federal Reserve's actions?

The speaker believes the Federal Reserve is being data-dependent and will react if necessary. Overreacting could exacerbate problems, particularly with the carry trade.

What impact could the current high interest rates have on consumers?

High interest rates could cause more pain for consumers, which might be underappreciated by investors. The effects of rate cuts are delayed and won't immediately stimulate consumer spending.

Why is the speaker underweight in consumer discretionary stocks?

The speaker is underweight in consumer discretionary stocks and overweight in later-cycle groups and defensives because of the belief that consumer sentiment and spending will continue to be negatively impacted by high interest rates and other economic factors.

What is the concern about the current positioning in the Nasdaq 100?

There is concern that the Nasdaq 100 is still vulnerable due to the $22.5 billion of long positioning, making it susceptible to any sentiment shocks.

What is the speaker's view on market valuation?

The speaker believes that current market valuations are inappropriate, with the market trading north of 20 times earnings, which is considered high. A more appropriate valuation in a soft landing would be around 19 times.

What role does leverage play in the current market environment?

Leverage is still high in the system, with people taking on more risk. This is concerning because it increases the vulnerability to economic shocks.

Why does the speaker expect earnings to be weaker in the second half of the year?

The speaker expects earnings to be weaker in the second half due to tough comparisons from last year and an elusive pickup in orders. There is skepticism about whether order books will improve in September, which is critical for a reacceleration.

How does the speaker interpret recent inflation data in relation to the stock market?

The speaker suggests that weaker inflation data might be bad news for stocks because it indicates a loss of pricing power for firms. However, it could be good news for bonds and aligns with the speaker's preference for defensive stocks.

Outlines

00:00

📉 Market Correction and Consumer Slowdown

The speaker discusses the recent market correction, attributing it to various factors including a shock in equity markets and the unwinding of carry trades. They predict a range-bound market due to slowing consumer spending, particularly in services, and the challenge of expanding multiples in a slowing growth environment with high earnings expectations and a reluctant Federal Reserve. The speaker also touches on the lag in consumer response to interest rate cuts and the underweight position in consumer discretionary stocks, suggesting a defensive stance in the current market.

05:02

📈 Earnings Growth and Valuation Concerns

This paragraph delves into the expectations for earnings growth in the second half of the year, suggesting it will be weaker due to difficult comparisons from the previous year and elusive order book growth. The speaker highlights that forward next 12-month earnings growth is peaking, which traditionally leads to a decrease in multiples. They discuss the current market multiple of over 20 times and suggest a fair market multiple in a soft landing scenario would be around 19 times. The speaker also addresses the implications of lower expected inflation on stocks and bonds, favoring defensive stocks in the current economic climate.

Keywords

💡Correction

A correction in financial markets refers to a decline of at least 10% from the peak of a stock, bond, or other securities. In the script, the term is used to describe a downturn in the equity markets, suggesting a significant drop in asset prices. This is a key concept as it sets the stage for the discussion on market volatility and the factors contributing to it.

💡Carry Trade

A carry trade is an investment strategy where an investor borrows money at a low interest rate in one currency and invests it in another currency that offers a higher interest rate. In the transcript, the unwinding of the carry trade is mentioned as a contributing factor to market instability, indicating that investors are closing their positions due to changing market conditions.

💡Consumer Discretionary

Consumer discretionary refers to a category of stocks that includes companies whose products or services are not essential and can be delayed or forgone if consumers face financial constraints. The script discusses the underperformance of consumer discretionary stocks, which is tied to the broader economic theme of slowing consumer spending.

💡Multiples

In finance, multiples refer to the ratio of a company's share price to its earnings per share (EPS), often used to value stocks. The script suggests that market multiples are expected to contract due to slowing growth and high earnings expectations, which is a critical factor in determining the potential for new market highs.

💡Fed

The term 'Fed' is short for the Federal Reserve, the central banking system of the United States. The script discusses the Fed's reluctance to be proactive in cutting interest rates, which is a key point in the analysis of monetary policy's impact on market conditions.

💡Data Dependent

Being data dependent means making decisions based on the most current and relevant data. The script mentions the Fed as being data dependent, suggesting that their policy decisions will be influenced by the latest economic indicators, which is a key concept in understanding the central bank's approach to rate setting.

💡Basis Point

A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. The script refers to a potential 25 or 50 basis point cut in interest rates, which is a significant detail in the discussion of monetary policy adjustments.

💡Leverage

Leverage in finance refers to the use of borrowed money to increase the potential return of an investment. The script warns about the high levels of leverage in the system, which can amplify market volatility and is a key concern for investors monitoring risk levels.

💡Triple Leveraged ETFs

Triple leveraged ETFs are exchange-traded funds that use financial derivatives and debt to amplify (usually three times) the returns of an underlying index. The script mentions these as an example of the leverage in the system, highlighting the potential for exaggerated market reactions.

💡Earnings Growth

Earnings growth refers to the increase in a company's profits over time. The script discusses the expectation of weaker earnings growth in the second half of the year, which is a critical factor for investors assessing the future performance of stocks.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. The script touches on the implications of lower inflation for stocks and bonds, indicating that lower inflation could be a negative signal for equity markets due to its impact on pricing power and revenue growth.

💡NFIB Optimism Index

The NFIB Optimism Index is a measure of small business economic sentiment reported by the National Federation of Independent Business. The script references this index to discuss the state of business confidence and its implications for inflation and pricing power, which is a key economic indicator.

Highlights

The market is likely to be stuck in a range due to a recent correction and carry trade unwind.

Consumer spending is slowing, impacting both goods and service companies.

Markets need multiples to expand, which is challenging in a slowing growth environment with high earnings expectations.

The Federal Reserve is reluctant to be proactive and is criticized for being data dependent.

A rate cut may not immediately boost consumer spending.

There is a preference for defensive stocks given the current economic climate.

Housing market is unlikely to be significantly impacted by a 25-50 basis point rate cut.

There is still significant long positioning in the Nasdaq 100, making it vulnerable to sentiment shocks.

Asset owners and retail investors remain exposed, indicating high market leverage.

Valuation is considered inappropriate given the current economic uncertainties.

Leverage in the system is higher than ideal, posing risks for further market shocks.

Earnings expectations for the second half of the year are likely to be lower than the first half.

Firms planning price increases have dropped, indicating potential loss of pricing power and good news for inflation but bad for stocks.

Weaker inflation data could be bad news for stocks as it signals reduced pricing power.

Defensive stocks are favored due to their alignment with bond performance in times of economic uncertainty.

Transcripts

We thought it happened in the third quarter, so it just happened

immediately. And there's always different reasons for

why it happens. Like our general take on the correction

that we've seen is that we're probably going to be stuck in this range now.

But I mean, we had a pretty big shock. It wasn't just the correction we saw in

the equity markets, but then we had the carry trade kind of unwind.

And I don't know how people can sit back and feel comfortable with that.

The main thing, though, is what you guys have been talking about this morning.

Right? The consumers slow it.

All right. All the consumer services companies in

particular, it's not just the goods companies.

And that has to be resolved here. So the way we think about it is in order

for markets to kind of make a, you know, a new high, I mean, you need multiples

to expand. And that's going to be very challenging

in a world where growth is slowing, earnings expectations probably are still

too high for the for the second half of this year.

And a Fed that's reluctant to be proactive.

Okay. And I don't disagree that people are

criticizing the Fed. I'm like, well, look, they're just being

data dependent. I mean, and so they're doing their job.

They're they're going to react if they need to.

If they overreact, then that probably exacerbates the carry trade problem.

So they're not going to overreact. Whether you think you're going to get

that 25 or 50 basis point cut over in September, it's still more than a month

away. So is rates remain elevated?

How much more pain does the consumer see, do you think, investors are perhaps

under appreciating how much more pain there's left in their lags?

Right. It's not like the Fed cuts.

It's September 18th and the consumer goes to Home Depot and buys data, a new

washing machine on September 19th. Right.

Well, that's generally been our view, right?

I mean, we've been underway consumer discretionary and sort of overweight the

later cycle groups and defensives on that premise meaning, you know, we think

being defensive right here makes a lot of sense for for all the reasons you

mentioned, all these things work with with a big lag.

And I completely agree. In fact, our note this week, we

discussed this in detail, particularly housing.

Right. A 2550 basis point is going to do

anything, mainly because most people's mortgage rates are sub four, if not sub

3%. So you need 2 to 300 basis points of

cuts to really get some of these interest rate sensitive areas moving in

that that's just going to continue to weigh on consumer sentiment.

So in a way on consumer stocks. And so that's you know, that's how we're

set up. We're set up to be sort of underweight

debt space. And Mike, I want to get your thoughts on

some of the technicals here, specifically when it comes to

positioning in the big tech sector, because there was a note out from

Citigroup this morning saying that there's still 22 and a half billion

dollars worth of long positioning on the Nasdaq 100.

And in their view, that makes the index still pretty vulnerable here to any sort

of sentiment shock maybe at 8:30 a.m. tomorrow morning.

What are your thoughts on position right now after the few weeks that we've seen?

Yeah, I mean, the faster money crowd has adjusted significantly, even the

systematic strategies and some of the long, short community but the the asset

owners right retail long only that that crowd is still very exposed and so there

is length in the marketplace. It's not just Nasdaq 100.

It's kind of equities writ large. So the way we think about it right now

is the valuation is just inappropriate, right?

Valuation doesn't matter until it matters, and that's all it matters.

And we've been very adamant that 19 times is kind of a fair market multiple

in a soft landing. Okay.

So today we're north of 20 times still. So I just I don't it's very hard for me

to get excited about the index, which is why we're really focused at the stock

level and the second level, try and make money a little more on the carry trade

here, because the carry trade is not really isolated to the yen.

I think that's an important dynamic of this.

The other important dynamic, I think, is how much investors didn't realize how

much leverage was under the system. If you think about kind of what has left

to unwind these kind of exaggerated shocks, do you still worry that they

could be another one this year? Well, there's still a lot of leverage in

the system. I mean, so that I just sort of spoke

about equity length is high. Okay, Bond length is low.

So, I mean, people are skewed to having more risk.

And then you take into account the leverage in the system through products

like triple leveraged ETFs or, you know, daily expiration options just to

leverage in a system. These people are doing carry trades of

all sorts. Yeah, there's still a while.

There's more leverage in the system than there should be, given the uncertainty

still of the eventual outcome of the economic, you know, events that are

still in front of us. Speaking of those, you said you expect

earnings to be weaker in the second half.

We've had an excellent earnings season in the second quarter.

I think 11% is what we've seen in terms of profit growth year over year.

Why is the second half going to be harder, do you think, tough comps from

last year? Do you think we're not going to see a

continued broadening out of earnings growth?

So what part of it's expectation? So there's a big hockey stick in the

fourth quarter and there's been a lot of discussion around a pickup in orders in

the second half of the year that continues to be elusive.

So as we come into September and this is and we wrote about this this week to the

key data for us is going to be what are companies saying in September about

order books? If we don't see order books pickup in

September, your year is kind of shot in terms of seeing a re acceleration that's

now in the numbers. So we're open minded.

It could change, but I don't think it's going to be because the Fed's cutting

rates, it's going to be perhaps maybe people hunkered down a bit and now we

can see a re acceleration. But the the comparisons are difficult,

as you mentioned, particularly in the fourth quarter for the for the.

Seven. And that's part of the story, too.

And so the key thing that we look at is forward next 12 month earnings growth

that is now peaking. And when that peaks, that means

multiples come down. And that's as simple as I can make it.

So 20 times and 19 times, that's our baseline.

That would be kind of the lower than that range we worried about this

weekend, and that would be a place where I would get interested at the index

that's still four or five or 6% away. And then if it gets worse and and it

gets cheap, then we'd get really interested.

But that's like 17, 18 times. And so tying this into some of the

economic data that we've gotten in the past 24 hours, of course, we had the

NFIB optimism index come out. That was good news in interesting

detail. Within it, though, if you take a look at

the report, it showed that the share of firms planning price increases dropped

to a net 24%. That's probably good news for the

inflation picture. But I read that is basically these firms

are out of pricing power. It's a really good point.

And I think this is this is. Be careful what you wish for on

inflation. We've been talking about this for a

while. You know, the market did sort of make

its top okay. Part of that was on a good lower CPI

number. And we wrote about that in early July.

You know, weaker inflation data now is potentially bad news for stocks.

It's good news for bonds. Okay.

Bad news for stocks. Why?

Because that's pricing power to your point.

And the CPI in particular is more aligned to revenue growth than even the

CPI. So I'll be interested tomorrow to see if

we get the same data point. You know, I'm not I'm not excited for

stocks because inflation is surprising on the downside.

I'm excited that maybe my trade in bonds looks better and that's why we like

defensive stocks. And I think that all kind of syncs

nicely.