Where Are We In The Business Cycle: A Troubling Chart From Morgan Stanley
In its 2017 global strategy outlook note titled “Sparkle and Fade”, Morgan Stanley is bittersweet about the future. While on one hand, the bank – which until recent had one of the gloomiest forecasts on Wall Street (a quick walk down Adam Parker’s YTD memory lane should be sufficient) – is now recommending equities and urging the sale of Treasuries and other duration exposure, it also admits that the US is now well into the late stages of the cycle, financial conditions will tighten significantly, and that much more volatility is on the horizon: “by 2Q17, the market will confront a more hawkish Fed, a still-strengthening USD and a renewed moderation in China’s growth. Political reality may also bite, as high expectations for action by the new US administration become hard to meet.”
This is how MS summarizes its recommendations:
“our first theme for 2017 is the need to be flexible; the second is that the distribution of outcomes has grown fatter. The gains in a plausible bull case look larger than before, fueled by the prospect of fiscal expansion, rising earnings and a return of true ‘animal spirits’. But the downside tail has also grown. Cycle models suggest that DM markets are already deep into the final expansionary stage. DM policy easing is coming to an end. The likelihood of booms and busts is far greater. And geopolitical risk looms large.”
On the bullish side, MS writes a trend of rising yields, steeper curves and better earnings has been in place for months. It forecasts that this trend will continue through 1Q17, as still-easy year-over- year comparisons mean headline inflation and global earnings continue to rise. The bank also points out something the Fed is well aware off: avoid giving the market much, if any, information. Namely, “an initial lack of policy clarity from the Trump administration may actually be helpful allowing investors to believe that the US ultimately will pursue ‘good’ projects (e.g., infrastructure spending) and avoid ‘bad’ ones (trade protectionism), while dangling the possibility of large corporate tax cuts. “
However, shortly thereafter the initial optimism will fade and by 2Q17, this picture is set to change: global yields and USD to rise in 1Q as markets anticipate that better growth and inflation will cause the Fed to hike twice later in the year. That will mean a material tightening in financial conditions.
Around the same time, China growth will slow as credit-fueled stimulus is dialed back. And high expectations that the new US administration will be market-friendly raise the likelihood of disappointment. Even with expectations of fiscal stimulus, Morgan Stanley’s full year 2017 GDP forecast is just 2%.
More troubling is that the expansion, already the 4th longest in US history, and set to be the third longest by the time Trump is inaugurated…
… is very long in the tooth.
Which brings us to the most concerning observation by Morgan Stanley, according to which 2017 is a year in which the bank’s odds of a boom and bust have materially increased, a finding consistent with a late-cycle US environment. So late, in fact, that one look at the chart below shows the US cycle has not only plateaued but is now stalling and is turning over.
This, as Morgan Stanley writes, “is a change. Our long-running narrative had been “slow growth, slow reflation, and slow policy normalization”, a backdrop that we’ve seen as favorable to credit. The prospect for more fiscal stimulus in the US and elsewhere affects all three. Our new forecasts call for higher growth, inflation and policy rates than before, an uncertain cocktail for an expansion that is already one of the longest on record.”
Higher growth? Ok fine, but based on what? An already record high debt balance and rising interest rates? Rising prices and (allegedly) wages, which eat into corporate profitability? A soaring dollar that will soon result in a sharp drop in US exports? Remember how until Nov 8 the only model everyone swore by was the “Fed Model”, according to which S&P multiples were at nosebleed levels because yields were so low, and so stock valuations are justified? Well, what happens to multiples when inflation spike and interest rates jump? Judging by the complete disappearance of any Fed Model mentions, that was a rhetorical statement.
Worse, as MS adds, its forecasts also imply the end of DM policy easing, sees higher probability of booms and busts (i.e., more volatility which traditionally is bearish) and it now expects six Fed rate hikes through YE18, with the ECB set to consider tapering in 2H17, and a shift of the BoJ’s 10yr yield target in 4Q17. Also, rather perplexingly, despit the collapse in EM currencies, Morgan Stanley believes that policy easing in 2017 is an EM story, with cuts likely in Brazil, Russia and Korea. It remains to be seen who these countries can afford to cut rates when their currencies are desparately in need of stabilization. Perhaps we will find MS’ answer in a few months.
For now, however, here are the two most likely “fat tail” outcomes:
- Bull case: US fiscal stimulus boosts growth just as EPS growth accelerates, leading to new highs in equity markets. Animal spirits, in both corporates and investors, return in a way they haven’t so far in this cycle. Higher yields turn out to be less of a drag than assumed, at least for the time being.
- Bear case: Higher growth and inflation could lead to a more hawkish central response than we expect. Corporate leverage is unusually high for this point in a cycle expansion. Risk premiums, while not extreme, are hardly ‘cheap’ across asset classes.
What does this mean for various asset recommendations:
- Overall: We reduce credit from OW to EW, upgrade equities to a modest OW (+3%) and add to cash (from +1% to +3%). We maintain a modest UW in government bonds. Given our view of ‘sparkle and fade’, we’d aim to keep exposure through liquid instruments, where possible.
- Equities: Reasonable long-run risk premiums (ex-US), a late-cycle market and high 12m return forecasts lead us to raise equities to a modest OW. But our regional views change. We lower US and EM, given weaker ‘cycle’ scores and a strong USD hitting 12m forecasts. Japan becomes our top market, with attractive long-run valuations, some cyclical strength, and good N12M EPS growth.
- Credit: Average risk premiums, higher odds of boom and bust and poor 12m return forecasts lead us to lower credit to EW. We forecast corporate spreads to widen, and prefer both securitized products and EM sovereign debt. In corporates, we prefer investment grade over high yield, Europe over US, and financials over non-financials.
- Rates: Still-low risk premiums, a late-cyle market and poor 12m returns are all consistent with a modest UW for government bonds, in our view. We see US 10yr yields rising to 2.50% by 4Q17, while 10yr Bunds rise to 0.90% as the ECB discusses tapering in 2H17. We think the US curve flattens vs. forwards on a 12-month view, while the DBR curve steepens.
- Cash: We raise our cash weight modestly, seeing this as prudent, given expectations that the next three months might require an outsized level of nimbleness.
- FX: We see the last leg of a USD bull market. USD/JPY goes higher (to 125 by 4Q17), while KRW and CNH also weaken. High carry offsets modest depreciation in BRL, RUB and INR.
- Volatility: We see a shift toward higher volatility. We switch from being sellers to buyers of credit volatility, and continue to like owning rate volatility, where we focus on EUR 10yr rates. We think calls are a good way to own the S&P 500, given low vol, a steep skew and a wider range between our bull and bear case forecasts.
Finally, here is a visual summary of the key themes for the coming year according to MS, which envision no less than 6 rate hikes by the end of 2018, suggesting Fed Fund rates rise to about 2% in two years: