Welcome to Thoughts on the Market.
I'm Mike Wilson, Morgan Stanley CIO and Chief U.S.
Equity Strategist.
Today we're going to try something a little different.
I have my colleague Andrew Palker from the U.S.
Equity Strategy team here to discuss some of the client questions and feedback to our views.
It's Monday, September 22nd at 1130 a.m. in New York.
So let's get after it.
Andrew, we constantly deal with client questions on our views.
More recently, the questions have been focused on our view that we've transitioned from a rolling recession to a rolling recovery and a new bull market.
Secondarily, it's about the tension between the equity market's need for speed and how fast the Fed will actually cut rates.
Finally, why is accelerating inflation potentially good for equities?
Where do you want to start?
Mike, in my conversations with clients, the main debate seems to be around whether the labor cycle and earnings recession are behind us or in front of us.
Walk us through our take here and why we think the rolling recession ended with Liberation Day and that we're now transitioning to an early cycle backdrop.
You know, we've had this view that in starting in 2022 with the payback and the COVID demand and from the pull forward that that began a what we call a rolling recession.
It started with the technology sector and consumer goods, where the demand was most extreme during the lockdowns.
And then, of course, we've had recessions in housing, manufacturing and other areas and commodities transportation issues.
It's been very anemic growth, if any growth at all, as the economy has been sort of languishing.
And what's been strong has been AI, CapEx, consumer services, and government.
And what we noticed in the first quarter and we actually called for this almost a year ago we said now what we need is a government recession as part of the finishing move.
And in fact, Doge was the catalyst for that.
We highlighted that back in January but we didn't know exactly how many jobs were lost from Doge's efforts in the first quarter.
But we got that data recently.
And we saw an extreme spike, and it actually sort of finished the rolling recession.
Even AI CapEx had a deceleration starting in the summer of 2024, something else that we've been highlighting.
And now we're seeing pockets of weakness even in consumer services.
So we feel like the rolling recession has rolled through effectively the entire economy.
In addition to the labor data, that now is confirming that we've had a pretty extreme reduction in jobs and of course, the revisions are furthering that.
What we saw in the private sector is also confirming our suspicions that the rolling recession is over, the number one being earnings revision breadth, something we've written about extensively.
We've rarely seen this kind of a V-shaped recovery coming out of Liberation Day which, of course, was the final blow to the earnings revisions lower, because that made companies very negative and that fed through to earnings revisions.
The other things that have happened, of course, is that Doge did not continue laying people off.
And also we saw the weaker dollar and the AI CapEx cycle bottom in April.
And those have also affected kind of a more positive backdrop for earnings growth.
And, like I said before, this is a very rare occurrence to see this kind of a V-shaped recovery in earnings revision breaths.
The private economy, in fact, is finally coming out of its earnings recession, which has been in now for three years.
And I would just add a couple of other variables as well in terms of evidence that we're seeing the rolling recovery take hold.
And that liberation day was kind of the punctuation or the culmination of the rolling recession.
And we're now transitioning to an early cycle backdrop.
So number one positive operating leverage is causing our earnings models to inflect sharply higher here.
Median stock EPS growth, which had been negative for a lot of the 2022 to 2024 period, is now actually turning positive.
It's currently positive 6% now.
The rolling correlation between equity returns and inflation break-evens is also now significantly positive.
That's a classic early cycle.
That's something we saw post-COVID, post-GFC.
And then lastly, just in terms of the market internals and kind of what, under the surface, the equity market is telling us.
So the cyclical defensive ratio was down about 50 into the April lows.
That's now up 50 from Liberation Day and is kind of breaking the downtrend that began in April of 2024.
So, in addition to the earnings revisions, feed shape recovery that you mentioned Mike, those are a couple of other variables as well that are confirming that we're moving towards recovery, an early cycle backdrop, and that the ruling recovery is commencing.
Okay, so we had the FOMC meeting.
As expected, the Fed delivered a 25 basis point cut.
Mike, what's your read on the meeting as it relates to equities and the reaction function?
Yeah, I mean, this is really what we expected along with the consensus.
We didn't have a different view that the Fed would give us 50 and gave us 25.
And some people have characterized this as sort of a hawkish cut and very different than what we saw a year ago when the Fed kicked off that part of the rate cutting cycle with 50 basis points because they probably were worried a bit more about the labor market than they were about inflation.
But you know, ultimately we think the labor data is going to get worse.
So the payroll data will prove to be worse because of the, the delay between the, the doge layoffs and when those folks can file for unemployment insurance, which should be in october.
And it's that delayed data that will then get the fed cutting in earnest, which is what's necessary for the full rotation to, kind of the lower quality parts of the market.
They haven't performed in the same way that we've seen prior cycles, like in 2020 or 08 09, because the Fed hasn't cut.
They're very far behind the curve.
If you buy into our thesis that You know, we had a rolling recession.
We had an employment cycle and they should be much more generous here.
So that tension between the Fed's delay to get ahead of the curve and the market's need for speed to get there sooner and more deliberately is where we think that you know we have to wait for that to occur to get the full rotation to the lower quality kind of really cyclical parts of the market.
Okay, so let's talk about the back end of the yield curve a little bit and why that's important for stocks.
In my dialogue with investors, there's a lot of focus here.
Just given what happened last fall, when the Fed cut at the front end and the back end of the yield curve moved higher, how should market participants think about this dynamic?
Yeah, I mean, I think this is an unknown known, if you will, because we saw this last fall where the Fed cut 100 basis points and the back end of the 10-year and 30-year Treasury market sold off.
That's the first time we've ever seen that in history, where the Fed cuts that aggressively and the back end moves out.
And this is a function of... just all the fiscal imbalances and the debt issues that we face.
And this is not a new issue.
So I think it remains to be seen if the bond market is going to be comfortable with the Fed, not ignoring the 2 target, but letting it run hot, as we've said.
We think ultimately they will have to let it run hot, and they will because...
That's what we need to have a chance at getting out of the debt problem.
And so that sort of risk is still out in the future.
I have less concern about that more recently because of the way the back end of the bond market has traded.
But it's something that we need to keep in the back of our mind.
If yields were to go back to 450, which is our key level, then that would be a problem.
As long as we're below sort of 450 and we're well below that now, we're close to four I don't think this is a problem at all.
Yeah, one of the points that our colleague in rate strategy, Matt Hornbach, has highlighted is that the difference between now and the fourth quarter of last year, when we saw that dynamic play out, was that, you know, the bond market was very focused on the uncertainty around the fiscal situation.
You know, we're going into an election.
There was a fair amount of uncertainty around what Trump would do from a fiscal standpoint.
And now that is a known known.
You know, we have the one big, beautiful bill signed into law.
We know what the deficit impact is.
So there is more clarity for the bond market on that front.
So that is one key difference now versus last fall and why we may not see the same kind of reaction in the rates market.
Mike, you brought up kind of run it hot, which was the title of our note from a couple of weeks ago.
I just wanted to get your take on why some inflation coming back is actually a positive for equities and why actually, the deceleration that we've seen in inflation over the last couple of years is one reason why earnings for small cap indices, for instance, have deteriorated so much.
And so if we're in this environment where the Fed is perhaps a bit more tolerant of inflation in 2026, why that's actually a positive for equities.
This is just an underappreciated sort of factoid that we actually identified back in 2020 and 21 as well, that when inflation is accelerating, that's a sign that pricing power is pretty good.
And we actually see broader earnings.
In fact, the best year for earnings, not just small caps but the called the equal weighted SP 500, was 2021.
And that was the year where, obviously, inflation was really getting out of control.
That was just pure profit for a lot of these businesses.
And so that earnings will be better.
Our call over the next 12 months is not about multiples or the Fed so much, but that we think earnings are going to end up being better than people expect, because a we've been through this three-year earnings recession.
There's a ton of pent-up demand okay and now inflation is re-accelerating as demand comes back and that is actually going to fall to the bottom line.
So not only is that good for stocks okay, but it's actually it's also why the equity risk premium can be lower, because if you want to hedge that risk of inflation moving higher, well then you should be willing to accept a lower equity risk premium relative to what is actually a pretty good base rate for 10-year yields close to 2 on a real basis.
So you know, that's why the equity risk premium can stay low and why stocks can accrue at a, you know, pretty high PE multiple, as these earnings come through better than expected.
And one of the reasons is that inflation actually is accelerating in some of these areas where it's been deflationary.
Lastly, Mike, you know, you brought this up briefly.
I want to address rotations under the surface of the market.
We took off our large cap buys a few weeks ago.
And, as you mentioned, kind of signaled our intention to get more constructive on small caps later this year in the fourth quarter.
Can you specifically kind of walk through the signposts that we're waiting for before pressing the long small cap trade here?
Yeah, I mean, this is probably one of the areas we've done a really good job of just staying away from the fray, meaning that we've been underweight small caps for really four years and they've underperformed that entire time.
I think the thing that we've been really patient about is just waiting for the Fed to lower rates to a level that's more conducive for these businesses.
That A need to obviously recap themselves, but then the cost of capital is just too high.
So that's number one.
But at the end of the day, I mean, that should translate into better earnings revisions.
And that also has lagged.
So it's a combination of the two.
The Fed getting ahead of the curve which I would define as Fed funds at least equal to two-year treasury yields, but hopefully below two-year treasury yields.
Right now, we're about 60, 65 basis points still above two-year yields.
And then the second one is this earnings revision breadth on a relative basis, small over large.
It's trying to turn up now.
It's been in a straight downtrend really for the last four years.
And so those two together affect a more robust relative outperformance.
And just to be clear, small caps have done really well since Liberation Day.
So in absolute terms, it's been great.
It's just the relative trade has not really worked yet.
That's where we're going to leave this conversation.
Thanks for speaking with me, Andrew, to explain some of the thinking behind our calls.
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