By Michael Wilson, chief US equity strategist at Morgan Stanley
Last week, our macro team released its outlook for 2019. While clients only see the final report, it requires extensive effort and debate among our strategists and economists to arrive at a cohesive and consistent view, with special help from Andrew Sheets and the entire cross-asset team. In the end, we settled on a new narrative that we titled The Turning Point, reflecting our conclusion that several key markets and biases will begin to reverse powerful and long-standing trends in the year ahead.
Specifically, we expect the following outcomes in 2019:
- US and European yields converge
- The US dollar makes a definitive cycle peak
- Emerging markets (EM) stocks and bonds outperform
- US equities and high yield underperform
- Within equities, value outperforms growth
Many of us were in Singapore this past week at our 17th annual Asia Pac Summit, where we discussed our outlook with a large and diverse group of clients. While pushback wasn’t overwhelming, clients didn’t exactly embrace our views, with the least support for value over growth and international stocks outperforming the US. Most agreed with our bearish stance on the US dollar but think we are early. On the other side of the ledger, many were in sympathy with our positive view on EM local debt.
We also encountered a high level of uncertainty, which usually leads people to hold on to their winners and avoid taking risks with a new view. This is a refrain I’ve often heard at major turning points, especially when existing trends have been so powerful and in place for so long – it’s hard to imagine them reversing. But anticipating changes in investment cycles is the essence of a macro strategist’s job. There’s no use identifying a turning point after it’s passed.
What do we see driving these changes? First, our economics team expects the US to slow materially next year from its blistering pace in 2018. The team thinks EM and European economic growth should remain steadier while Japan reaccelerates. This means growth differentials between EM and the US should widen back out just as they narrow between international developed economies and the US.
This should lead to interest rate convergence between the US and Europe, and a weaker US dollar, especially given how long the dollar the world is after eight years of buying US assets. From an earnings standpoint, difficult comparisons and the growing margin pressure we see only compound the issue of slowing US economic growth. This implies slower earnings growth in the US relative to international markets, driving better relative performance for international equities.
In the era of QE and fiscal austerity, equity investors have favored a barbell of quality and growth, a strategy that has worked brilliantly. However, with that era coming to an end, we don’t think this barbell will work so well. As we’ve discussed previously, a period of global reflation began two years ago with the bottoming of nominal rates and inflation breakevens in 2016. This coincided with the resynchronization of global growth between EM and developed markets, providing a powerful elixir for stocks of all types, as equity risk premiums were too high for this new world. Throw in the still exceptionally low interest rates at that time, and voilà, P/Es expanded materially as earnings growth accelerated. Now that US rates are up nearly 100% from the 2016 lows, combined with a strong argument for higher equity risk premiums, valuations are suddenly constrained, at least in the US.
Since Fed tightening was one of the pillars of our bearish outlook for risk assets in 2018, I would be remiss if I didn’t address Jerome Powell’s more dovish tone last week. I never doubted the Fed would consider financial conditions in its policy decisions. However, Powell’s comments do nothing to change our earnings outlook. With rates still hanging around 3%, there’s no reason to expect the S&P 500 to break above the top end of our previously stated near-term range (2650-2825). Some might argue, or be hoping, for an overshoot on valuation, but that’s a bull market view. I would caution that the rolling bear is still in the woods; he is simply resting at the moment.
Finally, writing this note before the Trump/Xi meeting on Saturday night at the G-20, I remain skeptical that anything will result that differs materially from what’s been leaked. More importantly, I don’t think trade tensions are the primary reason why asset markets have disappointed in 2018. As with the Fed’s dovish tilt last week, I see no reason to change our view of a range-bound market for the rest of the year.
Enjoy your Sunday. As for me, I’ll be in the stands rooting for the Chicago Bears to maul the New York Giants on Sunday afternoon.