Equity markets rallied to new all-time highs earlier this week on the news that the U.S.-China trade war might be entering a period of detente. As excited as some investors and traders have gotten over this development, those orientated for the long term may be asking themselves: will it mitigate some of the recessionary signals that have filtered through the data recently? A note from Morgan Stanley’s (MS, Financial) Chief Investment Officer Mike Wilson argues that it will not.
Weak earnings trump trade tensions
“For the past several months, I’ve been adamant about our view that slowing economic and earnings growth is more a function of a tiring U.S. business cycle than simply a reaction to rising trade tensions as others seems to believe. To reiterate: we think that tax cuts in 2017 were poorly-timed given the U.S. economy had finally reached escape velocity after a long but anemic recovery from the financial crisis. At the end of 2017, we had full employment, and companies were finally using their cash flows for capital expenditures, rather than just share buybacks and acquisitions - a necessary ingredient for sustainably higher productivity and real GDP.”
Essentially, the excessively generous fiscal policy enacted by the Trump administration in 2017 created surpluses in inventory and supply chains and led to outsized capital expenditures. The U.S.-China trade war then compounded these issues. Wilson believes this caused the Federal Reserve to hike rates faster than it would have liked to. All of this has put pressure on corporate margins, which in turn has spilled over into lower corporate confidence.
Will a trade truce fix this?
Wilson has been on record many times saying the fundamental slowdown in corporate earnings began before the latest U.S.-China flare up, and that even a resolution to the trade tensions won’t reverse what’s already in motion - the end of the longest business cycle in history:
“The risk of a mild economic recession in the U.S. has greatly increased over the past six months. The good news is that the markets already know this, which is why long-term Treasury yields are so low and defensive equities sectors like utilities, consumer staples and REITs have performed so well over the past year. Fortunately, we positioned our portfolios defensively beginning last summer. Now we expect the data to deteriorate further over the next few months, despite another trade truce between the U.S. and China this past weekend”.
The research note’s logic is that once more big institutions adjust to this idea, a stock market correction could quickly follow:
“If we’re right, the consensus will be forced to acknowledge our narrative, and we will hear more voices in the chorus calling for an economic recession. That kind of concern will create the buying opportunity we have been waiting for over the next few months. In rough terms, that means equity prices roughly 10% lower than today’s levels, so instead of chasing the fireworks this morning [Monday, July 1], be patient here and enjoy the fourth of July fireworks instead. The real buying opportunity hasn’t arrived yet.”
Long-term investors don’t really try to time market moves. But it is a widely accepted point that valuations are high across the board, so those who practice the value philosophy should probably be waiting for a correction of some sort to deploy their cash. This might be the one.
Disclosure: The author owns no stocks mentioned.
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