Mike Wilson: A Sudden Drop for Stocks and Bonds

09/26/22 • 3 min

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After last week’s Fed meeting and another rate hike, both stocks and bonds dropped back to June lows. The question is, will this turn to the downside continue to accelerate?

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, September 26, at 11 a.m. in New York. So let's get after it.

Last week's Fed meeting gave us the 75 basis point hike most investors were expecting, and similar messaging to what we heard at Jackson Hole a month ago. In short, the Fed means business with inflation and is willing to do whatever it takes to combat it. So why was there such a dramatic reaction in the bond and stock markets? Were investors still hoping the Fed would make a dovish pivot? Whatever the reason, both stocks and bonds are right back to their June lows, with many bellwether stocks and treasuries even lower. As we wrote a few weeks ago, we think investor hopes for a Fed pivot were misplaced, and Chair Powell has now made that crystal clear.

Secondly, we noted last week that the only remaining hope for stocks would be if the bond market rallied at the back end on the view that the Fed was finally ahead of the curve and would win its fight against inflation, while slowing the economy materially. Instead, interest rates spiked higher, squelching any hopes for stocks. While 15.6x price earnings ratio is back to the June lows, that P/E still embeds what we think is a mispriced equity risk premium given the risk to earnings.

Said another way, with a Fed pivot now off the table, the path on bond and equity prices will come down to growth - economic growth for bonds and earnings growth for stocks. On both counts we are pessimistic, particularly on the latter as supported by our recent cuts to earnings forecasts. We have been discussing these forecasts with clients for the past several weeks and while most are in agreement that consensus 2023 earnings estimates are too high, there is still a debate on how much. Suffice it to say, we are at the low end of client expectations. Interestingly, recent economic data have kept the economic soft landing view alive, and interest rates have moved above our rates team's year end forecast. From an equity market standpoint, that means no relief for valuations as earnings come down. This is a major reason why stocks sank to their June lows on Friday.

Ultimately, we do think economic surprise data will likely disappoint again, but until it does there is no end in sight for the rise in 10 year yields, especially with the run off of the Fed's balance sheet increasing. As such, our rates team has raised its year end target for 10 year Treasury yields to 4% from 3.5%. This is a very tough backdrop for stocks and epitomizes our fire and ice thesis to a T. In other words, rising cost of capital and lower liquidity in the face of slower earnings growth or even outright declines.

Finally, the Fed's historically hawkish action has led to record strength in the U.S. dollar. On a year over year basis the dollar is now up 21% and still rising. Based on our analysis that every 1% change in the dollar has a .5% impact on S&P 500 earnings growth, fourth quarter S&P 500 earnings will face an approximate 10% headwind to growth all else equal. This is in addition to the other challenges we've been discussing for months, like the pay back in demand and higher cost from inflation to name a few.

Bottom line Part 2 of our Fire and ice thesis is now on full display, with rates and the U.S. dollar ratcheting higher, just as the negative revisions for earnings appear set to accelerate to the downside. In our view, the bear market in stocks will not be over until the S&P 500 reaches the range of our base and bear targets, i.e. 3000 to 3400 later this fall.

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After last week’s Fed meeting and another rate hike, both stocks and bonds dropped back to June lows. The question is, will this turn to the downside continue to accelerate?

----- Transcript -----

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

Previous Episode

U.S. Economy: The Fed Continues to Fight Inflation

After another Fed meeting and another historically high rate hike, it’s clear that the Fed is committed to fighting inflation, but how and when will the real economy see the effects? Chief Cross-Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.

Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.

Andrew Sheets:] And on this special edition of the podcast, we'll be talking about the global economy and the challenges that central banks face. It's Friday, September 23rd at 2 p.m. in New York.

Andrew Sheets: So, Seth, it's great to talk to you. It's great to talk to you face to face, in person, we're both sitting here in New York and we're sitting here on a week where there was an enormous amount of focus on the challenges that central banks are facing, particularly the Federal Reserve. So I think that's a good place to start. When you think about the predicament that the Federal Reserve is in, how would you describe it?

Seth Carpenter: I think the Federal Reserve is in a such a challenging situation because they have inflation that they know, that everyone knows, is just simply too high. So they're trying to orchestrate what what is sometimes called a soft landing, that is slowing the economy enough so that the inflationary pressures go away, but not so much that the economy starts to contract and we lose millions of jobs. That's a tricky proposition.

Andrew Sheets: So we had a Federal Reserve meeting this week where the Fed raised its target interest rate by 75 basis points, a relatively large move by the standards of the last 20 years. What did you take away from that meeting? And as you think about that from kind of a bigger picture perspective, what's the Fed trying to communicate?

Seth Carpenter: So the Federal Reserve is clear, they are committed to tightening policy in order to get inflation under control, and the way they will do that is by slowing the economy. That said, every quarter they also provide their own projections for how the economy is likely to evolve over the next several years, and this set of projections go all the way out to 2025. So, a very long term view. And one thing I took away from that was they are willing to be patient with inflation coming down if they can manage to get it down without causing a recession. And what do I mean by patient? In their forecasts, it's still all the way out in 2025 that inflation is just a little bit above their 2% target. So they're not trying to get inflation down this year. They're not trying to get inflation down next year. They're not trying to get inflation down even over a two year period, it's quite a long, protracted process that they have in mind.

Andrew Sheets: One question that's coming up a lot in our meetings with investors is, what's the lag between the Fed raising interest rates today and when that interest rate rise really hits the economy? Because, you are dealing with a somewhat unique situation that the American consumer, to an unusual extent, has most of their debt in a 30 year fixed rate mortgage or some sort of less interest rate sensitive vehicle relative to history. And so if a larger share of American debt is in these fixed rate mortgages, what the Fed does today might take longer to work its way through the economy. So how do you think about that and maybe how do you think the Fed thinks about that issue?

Seth Carpenter: It's not going to be immediate. In round terms, if you take data for the past 35 years and come up with averages, you know, probably take something like two or three quarters for monetary policy to start to affect the real side of the economy. And then another two or three quarters after that for the slowing in the real side of the economy to start to affect inflation. So, quite a long period of time. Even more complicated is the fact that markets, as you know as well as anyone, start to anticipate central bank. So it's not really from when the central bank changes its policy tools when markets start to build in the tightening. So that gives them a little bit of a head start. So right now, the Fed just pushed its policy rate up to just over 3%, but markets have been pricing in some hiking for some time. So I would say we're already feeling some of the slowing of the real side of the economy from the markets having priced in policy, but there's still a lot more to come. Where is it showing up? You mentioned housing. Mortgage rates have gone up, home prices have appreciated over the past several years, and as a result we have seen new home sales, existing home sales both turnover...

Next Episode

Martijn Rats: Will Oil Prices Continue to Fall?

While the global oil market has seen a decrease in demand, supply issues are still prevalent, leaving investors to question where oil prices are headed next.

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Welcome to Thoughts on the Market. I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the current state of the global oil market. It's Tuesday, September 27th, at 2 p.m. in London.

U.S. consumers have no doubt noticed and appreciated a welcome relief from the recent pain at the gas pump. Up until last week, U.S. gas prices had been sinking every day for more than three months, marking the second longest such streak on record going back to 2005. This gas price plunge in the U.S. was driven in part by the unprecedented releases of emergency oil by the White House. But what else is happening globally on the macro level?

Looking at the telltale signs in the oil markets, they tell a clear story that physical tightness has waned. Spot prices have fallen, forward curves have flattened, physical differentials have come in and refining margins have weakened. A growth slowdown in all main economic blocks has pointed to weaker oil demand for some time, and this is now also visible in oil specific data. China has been a particularly important contributor to this.

However, prices have also corrected substantially by now. Adjusted for inflation, Brent crude oil is back below its 15 year average price. In this context, the current price is not particularly high. Also, the Brent futures curve has in fact flattened to such an extent that current time spreads would have historically corresponded with much higher inventories expressed in days of demand. That means, in short, that the market structure is already discounting a significant inventory built and/or a large demand decline.

Then there is still meaningful uncertainty over what will happen to oil supply from Russia once the EU import embargo kicks in later this year for crude oil, and early next year for oil products. The EU still imports about three and a half million barrels a day of oil from Russia. Redirecting such a large volume to other buyers, and then redirecting other oil back to Europe is possible over time, but probably not without significant disruption for an extended period. For a while, we suspect that this will lead to a net loss of oil supply to the markets in the order of one and a half million barrels a day. To attract enough other oil to Europe, European oil prices will need to stay elevated. The relative price of oil in Europe is Brent crude oil.

Elsewhere, there are supply issues too. We started off the year forecasting nearly a million barrels a day of oil production growth from the United States. But so far this year, actual growth in the first six months of the year has just been half that level. We still assume some back end loaded growth later this year, but have lowered our forecast already several times. Then Nigerian oil production has deteriorated much faster than expected, currently at the lowest level since the early 1970s. Kazakhstan exports via the CBC terminal are hampered, OPEC's spare capacity has fallen to just over 1%, and the rig count recovery in the Middle East remains surprisingly anemic.

The long term structural outlook for the oil market still remains one of tightness, but for now this is overshadowed by cyclical demand challenges. As long as macroeconomic conditions remain so weak, oil prices will probably continue to linger on. However, that should not be taken as a sign that the structural issues in the oil market around investment and capacity are solved. As we all know, after recession comes recovery. Once demand picks up, the structural issues will likely reassert themselves. We have lowered our near-term oil price forecast, but still see a firmer market at some point in 2023 again.

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