Andrew Sheets is Morgan Stanley (MS, Financial)'s chief cross asset strategist. He was recently in the news for his bearish call on U.S. equities, saying that easier monetary policy would be more than offset by weaker economic growth. In this brief note, he summarized why the investment bank has taken such a stance.
Why the downgrade?
As mentioned, Morgan Stanley recently downgraded its view on global stocks, lowering its recommendation to "Underweight" -- its lowest in five years. Why did it do so? One reason for the downgrade was the results provided by the bank’s equity strategists:
“At the moment, a key view of these teams is that the market’s expectations for corporate earnings over the next twelve months are simply too high, limiting the potential for further market gains. Across the stock markets in the US, Europe, Japan and emerging economies, Morgan Stanley’s equity strategists forecast gains of just 1% over the next twelve months.”
This is just one way to estimate stock market returns, though. Another way to do so would be to look at what has happened in the past when valuations and economic data have been similar to what they are now. Doing so gave a similar answer:
“Overall global equity valuations are slightly expensive, which means that our starting point for returns should be slightly below average. But what really hurts this estimate is the economic backdrop. When the yield curve has been this flat, when unemployment has been this low, when consumer confidence has been this high, and importantly, when all three of these factors have been stalling out, the next twelve months return for global stocks has been well below average.
"Put together, the average expected return to our strategists’ twelve-month price targets and our expected return based on an economically-adjusted valuation level is just 2% for global equities - that’s the lowest reading in five years.”
What are the risks?
What could precipitate this slowdown in returns? Sheets identifies two main risk factors: earnings and seasonality. The second-quarter earnings season has just kicked off, so let’s start with that:
“While estimates for the current quarter have come down, we think that there’s a risk that companies use this opportunity to lower their expectations for the entire year. What would warrant such a change? When companies last updated investors for the first quarter, it was mid-April. Since then, a lot has changed. US-China trade talks have deteriorated significantly, global data has weakened and our economists have lowered their growth forecasts in the US, Europe and China.”
Seasonality matters because the third quarter is typically a weaker period for earnings. Moreover, limits on stock buybacks in earnings season remove the ability of companies to support equities.
“Ahead of earnings, companies lose the ability to buy back stock, limiting an important source of market support. After earnings, you’re about to enter a two-month period between July and August that historically sees much weaker-than-average market returns. For all those reasons, we think that it makes sense for investors to reduce their overall stock holdings to below-average, or underweight levels.”
Disclosure: The author owns no stocks mentioned.
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