This week, the notably bearish chief investment officer of Morgan Stanley (MS) reiterated the bank’s position on equities: Stay in boring defensive stocks, as it appears that the market is at all-time highs and economic data is weak. In particular, he stressed that a sudden halt of interest rate hikes (like the one announced last week) is not the same as a planned, gradual pause. Morgan Stanley clearly sees the Fed’s about-face on monetary policy as a bearish signal, and one that shows the central bank is worried about the state of the economy.
Monetary easing, but at what cost?
Some market participants may have interpreted the pause in rate hikes as a signal that the spigot of easy money will be turned back on and that we are in store for another bull run. Morgan Stanley’s CIO disagreed:
“Last week, the Federal Reserve had just completed their two-day meeting, and essentially told us that they are done hiking interest rates this year, and maybe for the entire cycle. Perhaps more importantly, they also told us that they would stop shrinking its balance sheet by September, which is sooner than what they had told us before. The shrinking of the Fed’s balance sheet has been our chief concern over the past year, as it relates to equity markets”.
It should come as no news to value investors that the market as a whole is currently severely overbought, but this becomes even more apparent when one considers that price-earnings multiples for the S&P 500 have risen by 24% since December’s sell-off:
“There are two new issues to consider. First is valuation. Last week’s move was not a total surprise to markets, since the Fed has been signalling a much more dovish policy since January 4th. As a result, equity markets have rallied strongly all year, and to put this in context, price-earnings multiples of the S&P 500 rose by 24% from the lows on December 26th to last week’s highs on Thursday afternoon. Based on our valuation framework, we reached the high end of what we think is a tolerable level of valuation, even with the fall in interest rates since then.”
A worried Fed
“The second thing to consider is the real message behind the Fed’s dovish shift last week. In my view, the abrupt and premature ending of the Fed’s balance sheet reduction is more akin to an interest rate cut rather than just a pause in tightening. Such an interpretation is important, because historically when the Fed is cutting interest rates, versus pausing rate hikes, it tends to be negative for equities. The reason for this is pretty clear - if the Fed feels the need to shift to a policy-easing stance, they must be more concerned about growth at the margin. And given the abruptness in their shift this time, that should weigh on equity prices, particularly given the fact that they are now fully valued.”
In other words, the simple fact that the Federal Reserve has capitulated on its previously stated goal of two rate hikes in 2019 is a sign that they are worried about the direction that the economy is taking. Add to that disappointing labor data and the lagging manufacturing results of the last few months, and you have a recipe for a bearish crunch.
Boring is beautiful
Therefore, it makes sense to hold off on buying more equities at this point in time. The note concludes with pointing out that defensive stocks historically over perform in times like this, and in fact they already have:
“Since last summer, utilities and staples have returned approximately 16% and 10% respectively. This compares with returns of just 3.5% for tech and -10% for small caps. These better returns in defensive sectors have also come with a lot less volatility for investors, and we think that it will continue as first-quarter earnings season approaches. So we stay the course with our more conservative recommendations until either valuations come down to more appropriate levels, or we see a real trough in economic and earnings data.”
Disclosure: The author owns no stocks mentioned.
