Morgan Stanley: Don't Fight the Fed

One of the main features of 2019 has been the disconnect between the stock market rally and the slowing fundamentals that are apparent in economic data. While equities have rallied sharply since they bottomed in late December, numerous indicators such as the yield curve and nonfarm payrolls suggest that underlying growth is slowing down. A recent research note from Morgan Stanley (MS, Financial) explores this phenomenon.

Fighting the Fed is a bad idea

“If 2018 was the year of ‘Don’t Fight the Fed,’ 2019 still is, just in reverse. [Last year] the weakest assets got hit first and the hardest. When it was over, every global financial asset category we track underperformed cash for the year, which has never really happened in modern times. However, with the Fed’s dovish pivot in early January, 2019 has turned out to be the mirror image of 2018, with every asset category rallying sharply, and recouping much, if not all their losses from last year. Fighting the Fed in either direction is a bad a idea.”

Morgan Stanley has been notably bearish over the past several years, especially compared to some of its peers. Nonetheless, it appears as if the investment bank underestimated the impact of the Federal Reserve’s rate hike halt earlier this year. At this point, stocks (and other assets) have become much more expensive compared to where they were at the end of 2018. The note points out the recent rally in bitcoin, one of the most speculative assets available, is evidence that investors may be running out of options.

"With little upside remaining from a valuation perspective, we’ve noticed the rally taking on a more speculative nature in the past month, as investors seek out any remaining assets that have yet to reflate from the Fed’s actions. Perhaps the best case in point is bitcoin, which has rallied more than 30% in just the past few weeks. We think it’s instructive to point out that bitcoin was the first asset to top in the rolling bear market back in December 2017, making its strong rally recently a bookend to the big decline and recovery of the past year.

It’s critical, but also difficult, to determine how much of the rise in valuations is simply the loosening of financial conditions, versus expectations that growth will re-accelerate. However, at current valuations I’m confident that if we don’t get some hard evidence of the re-acceleration in earnings growth that’s now baked into consensus expectations, investors will be disappointed, unlike in January when bad earnings results were greeted with positive stock price reactions.”

First-quarter earnings around the corner

It will be interesting to see whether companies interpret the stock market rally of the last three months as evidence the brief bear market of 2018 is over, or whether they will take a more sober look at the underlying economic data and guide earnings lower. The research note suggests investors take any strong guidance with a grain of salt and adjust their own expectations lower:

“With first-quarter earnings season about to begin, the moment of truth has arrived to see if companies will continue to guide for a second-half recovery or lower the bar further. Appreciating that company managements are also human beings, we suspect that the powerful equity rally has left them in a better mood, and may encourage them to remain steadfast in the second-half recovery mantra, even if the evidence of one remains uncertain. Of course, we have no idea how companies will guide, but our leading earnings indicator continues to strongly suggest calendar ‘19 estimates are still too high. Therefore, strong guidance should be viewed with a skeptical eye and we would prefer to see the bar lowered further.”

If first-quarter earnings are weaker than expected, then stocks should react negatively, in contrast to January, when they did not. In particular, glamour growth stocks will be hit the hardest, as they are the most out of line from their intrinsic value:

“The bottom line is that first-quarter earnings season is starting this week, and we suspect that bad news will be met with weaker prices in stocks, not stronger ones like in January. The areas that appear to be most vulnerable are expensive growth stocks like software, and other late-cycle defensive areas that have also been bid up recently on slowing economic growth and falling interest rates. For those who want to be tactical, now is a good time to consider reducing equity exposure, given the elevated risk as we enter earnings season”.

Disclosure: The author owns no stocks mentioned.

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