Gold Ten Data, August 8, Morgan Stanley (Morgan Stanley) chief U.S. equity strategist Michael Wilson (Michael Wilson) said that looking back over the past year, the Fed’s performance was terrible. Even the Fed itself admits that it has made a serious miscalculation of inflation in the past. To restore its reputation, the Fed quickly embarked on its harshest monetary tightening cycle in a generation. While Morgan Stanley had assumed the Fed would have to take aggressive measures in 2022, Morgan Stanley had not anticipated that the Fed’s current rate hike cycle would be so protracted and aggressive.
Of course, Wilson affirmed the swift remedial action taken by Fed Chairman Jerome Powell and a host of policymakers when they realized they were wrong. But Wilson noted that the Fed’s efforts have sparked market turmoil, with both stock and bond markets having their worst starts in decades this year.
However, long-dated U.S. Treasuries have posted one of their strongest two-month gains on record since reaching their highest for the year in June. At the same time, the 2/10-year U.S. Treasury yield curve inverted by as much as 44 basis points. Perhaps most importantly, Wilson noted, the market’s inflation expectations have now fallen sharply and are closer to the Fed’s long-term goal of 2 percent. Whether expected or not, the bond market appears to have rapidly shifted from an “economic barometer” to a “Fed follower.” Meanwhile, U.S. stocks have also rebounded, rising sharply from their June lows. In short, the stock market also appears to share the market’s bullish inflation expectations.
As Morgan Stanley has highlighted over the past two-plus years, this economic cycle may be one of the hottest yet shortest on record. It all started with the decisions governments made to protect their economies during the pandemic: lockdowns and unusual fiscal and monetary stimulus. In April 2020, Morgan Stanley warned that this “flooding” monetary policy could lead to a surge in inflation. Morgan Stanley also believes that many companies have become too profitable due to surging demand and government subsidies for hiring costs.
A combination of high consumer demand and high government employment subsidies has led to unprecedented and unexpected levels of operating leverage for many companies, Wilson said. Most investors, including Morgan Stanley, underestimate how positive this scenario would be for bonds and stocks. In fact, when the prices of bonds and stocks are higher, the more unreasonable the higher prices are, and the higher the company’s profits are. To complicate matters, this surge in consumer demand is only temporary for many companies.
However, it is widely believed that this phenomenon is only due to a subset of “pandemic winners” (e-commerce, streaming, etc.), rather than the conclusion that we entered an economy with excessive consumer demand and excessive corporate profit levels cycle.
Fast-forward to this year, and the Fed has embarked on this tightening cycle, declaring that it will do whatever is necessary to control inflation. Stock valuations plummeted on the news, with the S&P 500’s price-earnings ratio down as much as 30%. Today, stock investors seem to agree with the bond market that inflation has peaked, so the Fed doesn’t need to prolong the tightening cycle for too long. As a result, the price-to-earnings ratio has expanded to 17.5 times EBIT per dividend as interest rates have fallen.
Morgan Stanley agrees that inflation has peaked. It believes that, in fact, inflation expectations have peaked in April this year, and have now fallen sharply. However, the equity risk premium (ERP) fell back to 285 basis points. In Morgan Stanley’s model, fair value is already close to 400 basis points.
Note: Equity risk premium ERP (equity risk premium) refers to the difference between the return on a market portfolio or a stock with market average risk and the risk-free return.
With 10-year U.S. yields already down sharply, it’s hard to argue for a higher valuation with both earnings estimates and PMIs down, Wilson said. So the question stock investors should really be asking now is whether lower inflation is good for corporate earnings .
Morgan Stanley’s view is the opposite of what rising inflation will do to corporate profits in 2020-21. Not only that, but the market has generally underestimated the nascent cycle of negative operating leverage, just as the market has generally underestimated past cycles of positive operating leverage when inflation has risen.
Another question is, what is the gap between market expectations and reality?
The strong U.S. non-farm payrolls report for July released last Friday showed that U.S. companies have not yet protected profit margins by laying off workers; and the market has also delayed expectations for the timing of the Fed’s “dovish turn”. In short, inflation is likely to fall from here. While that may be good for bond and stock valuations, it’s bad for corporate profits. That said, as an investor, don’t have high expectations.
The strong rally in the stock market has led investors to believe that the bear market is over and to look forward to a bull market. However, Morgan Stanley believes that “inflation has peaked” alone does not prematurely assume the bear market is over. The next bear market in U.S. stocks may not come until September, when corporate earnings expectations will better reflect the impact of negative operating leverage. Although it is still a while away, with such a high valuation, Morgan Stanley believes that the best stage of this round of US stock market rally is over.