The trade war continues to escalate with President Trump now threatening Mexico with tariffs in an attempt to curb illegal immigration into the United States. Meanwhile, there is little sign of progress in the U.S.-China trade talks. Investors are understandably worried, and this attitude is reflected in stock market valuations across the globe, a far cry from the heady days of early 2019. Indeed, the latest selloff has caused many an analyst to revise their expectations for the year downward.
One institution, however, that has been pretty much dead-on accurate in its assessment of market risk this year has been Morgan Stanley (MS, Financial), whose research we frequently analyze. A recent report from its equity strategy desk encourages clients to think like real value investors.
What goes up must come down
Equity markets have been selling off over the last several weeks, while government bonds have traded higher. This is a classic sign of risk-on sentiment taking over the market as investors seek safer assets. Although the main catalyst for this has been the trade war, there are reasons to believe more prudent investors are concerned about economic fundamentals too. Indeed, Morgan Stanley’s research desk has been arguing this all throughout 2019, and it stuck to its call in this report:
“I believe that the U.S. suffers from three excesses created by the tax cuts and tariffs implemented in 2018. First, there was excessive capital spending last year as every company had more after-tax profits, and some repatriated overseas cash back home. Second, many companies built excess inventory over the past 12 months as they double-ordered to offset tightness in the supply chains from an overheating economy. This tightness was exacerbated by the tariffs. And finally, the labor market is strong. While that’s a good thing for workers, it’s not so great for companies who have to pay more to good employees who are also harder to find.”
The report argues that the excesses of the previous year will ultimately result in lower capital spending, a decline in inventory and "potentially a weaker labor market." I recently wrote about the weakness in the auto sector as larger inventories have built up and demand weakens. We may be seeing this pattern repeated across other industries:
“We already have evidence of slower capex growth in the technology and industrial sectors, and with the softer retail earnings over the last few weeks, there is also increased chances that an inventory burn is about to begin. Both of these factors will weigh on economic growth, but the biggest risk is what companies decide to do with employment, because that will determine whether the U.S. economy avoids a recession or not. We don’t know the answer yet, but that risk is growing.”
Be greedy when others are fearful
Although major investment banks like Morgan Stanley aren’t typically considered in the category of pure value investors, the report echoes a famous Buffettism that advises action when those around you are paralyzed by fear:
“We recommend that investors stay the course with more defensively-positioned portfolios than normal; however, it’s a time to start listening carefully for others to start adopting a more conservative stance in their rhetoric.
Once that happens, it's usually time to get more aggressive. We think that day is coming this summer, or perhaps by early fall. It will require some fortitude because at that point the newsflow could be quite negative, and the market could feel more unsettled than it does today - and those are the best times typically to invest.”
Disclosure: The author owns no stocks mentioned.
Read more here:
- Li Lu: What Value Investors Can Learn From Early-90s Russia
- Is the Auto Industry in Trouble?
- Warren Buffett: Life and Debt
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