“Omicron Didn’t Start The Fire”, But Morgan Stanley Sees Powell Raining Fire And Brimstone On The Market
Every time stocks slump, Morgan Stanley’s bearish chief equity strategist who has a 4,400 “base case” year-end price target for 2022…
… emerges from his bearish crypt with a wry “I told you so” smile, at least until the BTFD crew emerges after the latest Fed greenlight, and sends markets surging once again. For now, however, stocks remain stuck in the high-vol no man’s land of negative gamma, where bearish sentiment dominates and fear is “extreme” as the latest Fear and Greed index shows.
And across a Wall Street landscape where most strategists and analysts just turned bullish to justify their cheerful 2022 outlooks and are understandably keeping a very low profile these days, Wilson’s bearish posture allows him to take a (somewhat early) victory lap. However, if the Morgan Stanley strategist is correct, the pain is only just beginning.
Yet while sentiment has been clearly risk-off since it was triggered by the illiquid, Black Friday panic about the Omicron variant, Wilson contends in his latest Weekly Warm-Up note (available for pro subs in the usual place) that the “new COVID variant started the ruckus for markets, but we view that as secondary to the real culprit—the Fed’s more aggressive response to the “on Fire” data.” Here he reminds readers that “lower valuations is our call for 2022, and the Fed’s accelerated taper just brings it forward.”
As the bearish strategist expands, over the past week markets faced 2 new curve balls—Omicron and a faster taper of asset purchases by the Fed. With respect to the new variant, Morgan Stanley – like JPMorgan – remains hopeful that this will prove to be just another wave of COVID that potentially leads to even greater immunity via vaccines and/or natural recovery from the disease.
Furthermore, Wilson says that it appears unlikely that any new widespread lockdowns will be imposed on US soil which is the real risk to economic and business activity:
While many are referring to the slowdown last summer from the Delta variant for comparison, we still believe most of that slowdown was attributable to the natural ebb of the cycle post the peak rate of change in the Spring. Finally, the recent spike in cases appears to be mainly the Delta variant and looks more like it could be a seasonal increase such as many were expecting.
In other words, Wilson writes, the severity of the sell off in equity markets the day after Thanksgiving was not necessarily due to Omicron. Instead, Wilson thinks the new variant served as the trigger to end a speculative seasonal rally that was ignoring this seasonal wave along with a lot of other visible risks. Importantly, the decline over the past few weeks still leaves P/Es higher than they were 2 months ago with unfinished business, and we think this has more to do with the mid cycle transition than anything else.
So if Omicron was a trigger but not the driver for the move lower, what is the catalyst for the recent plunge in tech names, a move which SocGen’s Albert Edwards last week predicted would only accelerate to the downside, and “End Up Sinking Like The BRICs.”
According to Wilson, in addition to our expected resumption of the downward trend in multiples that began back in March (see chart above), the most important development for markets over the past few weeks was the pivot made by Fed Chair Powell during his Congressional testimony.
- First, Powell admitted the Fed made a mistake thinking inflation would be transitory. Instead, he acknowledged the Fed would need to address the higher levels of prices by withdrawing asset purchases at an even faster rate than he previously suggested. As a result of his comments, Morgan Stanley’s house call is now for the Fed to be completely done with QE by the end of March, or twice as fast as previously forecasted. That needless to say, is a very speedy withdrawal of monetary accommodation, and one that is likely to leave a mark on asset prices (because, contrary to what you may have read from various clueless hacks, tapering is tightening, because flow matters much, much more than stock).
- Second, the recent drop also fits with the “Fire” part of Wilson’s narrative first discussed after the Fed’s Jackson Hole meeting back in August when it became clear they were going to start tapering around the end of the year. As shown in Exhibit 1, valuations began to de-rate at a more accelerated rate in early September in anticipation of the official announcement later that month—i.e. tapering is tightening for markets even if it isn’t for the economy. Then, P/Es rose during October as the seasonal year end rally began as we anticipated. However, as Wilson correctly noted, the rise would prove to be temporary before the P/E normalization would resume, sometime after Thanksgiving. He nailed that timing to a T.
Of course, this early tapering was in direct response to the very high inflation and red hot labor market we have been experiencing. The more aggressive pace is also consistent with the current priorities of the White House that wants to pass another fiscal stimulus package. That, as Wilson puts it, is “hard to do with inflation running wild” and it appears to Wilson that Chair Powell is taking more responsibility for the high inflation that is plaguing many consumers. Indeed, as discussed previously, the sharp fall in consumer and small business confidence – not to mention Biden’s approval rating…
… can be attributed mostly to high inflation and this has the full attention of the White House as we enter a critical mid term election year for both parties.
Here Wilson has one final thought for investors to consider: this White House is more focused on inflation than the stock market, the opposite of the prior administration. Therefore, according to Morgan Stanley, “it’s possible we won’t see the same pressure on the Fed to back off if markets continue to wobble like they did in late 2018 for the same reason—a Fed determined to tighten policy, aka on “auto-pilot.”
That is needless to say, a very bearish possibility, yet we don’t agree with Wilson that Biden is willing to sacrifice markets just to ease consumer inflation, especially since oil has already tumbled from its multi-year highs and gasoline prices are set to follow.
Bottom line: according to Wilson, “the Fed is preparing to remove policy accommodation faster than what many investors were expecting due to higher inflation and a labor market that is rapidly approaching full employment—i.e., “Fire”.” Under such circumstances, the Morgan Stanley strategist argues that it doesn’t seem to make sense for the Fed to be buying assets any longer, especially at a pace of $1.5T per year. And while many bond market participants had started to price this accelerated taper in the past few weeks, the fact that Powell was not deterred by the growth risk from Omicron may have surprised some, leading to the sharp fall in risky assets.
Alas, neither Wilson – nor anybody else for that matter – has explained how tighter financial conditions will offset what is basically a supply-chain driven problem that monetary policy has zero control over (as discussed in “No One On Earth Has Any Idea How Monetary Policy Can Alleviate Supply Chain Constraints“). The tightening of monetary policy, however, will be quite capable to not only launch a bear market but also an economic recession. Needless to say, both would be catastrophic for the Democrats ahead of the midterms.
Wilson also believes that the Fed seems determined to remove accommodation more aggressively so it can be in position to raise rates if inflation rates remains higher than desired. This is the bank’s “Fire” narrative which suggests valuations remain vulnerable, the key call in its established “Mid Cycle Transition” narrative and year ahead outlook.
In essence, Morgan Stanley’s view is that the Fed’s faster taper simply brings this risk forward and it’s no coincidence the most highly valued stocks have seen the biggest hit over the past few weeks, a process that really began as far back as February when back end rates moved materially higher. And – once again – Wilson reiterates his now well-known view, one which we fully agree with, that tapering is tightening for the markets and it will lead to lower valuations like it always does at this stage of any recovery.
How much lower? Wilson forecasts S&P 500 forward P/Es to fall to 18x, or approximately 12% below current levels. Obviously, for the more expensive parts of the market, that decline will be larger
But what is Wilson is wrong and the view of rampant inflation is frozen in a world where Omicron, or something else unexpected, results in a deflationary spike. As the MS strategist responds, while he is not that concerned about Omicron as a major risk factor for equities (as
things stand now), especially since the bank’s growth concerns already incorporated a seasonal spike in cases and Omicron may simply be reminding people of that risk that was always there, the Omicron variant may have the effect of curtailing demand that is already on a decelerating path. But, that – Wilson argues – is a story for 1Q. For now, it’s about the “Fire” and the response by the Fed and other central banks. That response (tightening) is having its predictable impact on valuations, a process that began in September, reversed in October and is now resuming and unfinished, in our view.
Meanwhile, looking across other asset classes, Morgan Stanley notes that a more aggressive Fed path did not translate to the Treasury market. Instead, bonds ripped with yields completely breaking down with the yield curve now down more than 80bps from its high back in March. That peak coincided with the peak rate of change in growth and the beginning of the mid cycle transition. The fact that the yield curve isn’t showing any signs of bottoming yet tells Wilson that “the mid cycle transition isn’t over which means the de-rating isn’t finished yet either.“
Finally, addressing a question in the back of investors’ heads, namely “What Would Make Morgan Stanley More Bullish”, Wilson answers that “first and foremost is valuation. Our target multiples are still more than 10% lower than current levels. Second is better visibility on the 1H deceleration we see for earnings growth.”
It appears that a lot of pain has to come first, before we get material comfort on either of the two…
Mon, 12/06/2021 – 14:15
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