Having gotten dragged kicking and screaming into validating the late-2019 market meltup and even hiking his own year-end price target for the S&P500, Morgan Stanley’s bearish equity strategist, Michael Wilson, was looking for just the right catalyst – such as the Chinese coronavirus pandemic – to announce that the Fed-liquidity driven rally is over and a long-overdue correction has begun.
The Fed still injecting ample liquidity into the market every month to the tune of about $60-80BN, Wilson finds himself trapped as he can’t go “full bear” and instead has to be cognizant that the factor that dragged him into the bullish camp is still there, and will likely be there (or become larger) throughout the pandemic, which limits how bearish Wilson can be.
Wilson was quick to acknowledge that “liquidity has played a large role in the rally since October and index level prices appear ahead of the fundamentals” and as such, while he suspects “the first correction since October has begun”, it will be contained to 5% or less for the S&P 500 as the Fed won’t let sto(n)cks drop too much as “liquidity remains flush and high quality/low beta/defense (i.e. S&P 500) outperforms lower quality/high beta/cyclicals (small caps, EM, Japan, Europe).”
Wilson believes it may have been holding back the performance of small caps all along, at least on a relative basis. In short, “it makes sense to stay underweight small caps until these credit downgrades subside, earnings expectations get more realistic, or the US economy shows signs of reacceleration rather than just stabilization.”
Alas, and as Eric Peters said yesterday when he cautioned that “in each downturn, central bankers must step in more and more aggressively…. the process is reflexive and ultimately leads to a Minsky extreme,” this means that while near-term risks have increased, Morgan Stanley believes that “corrections at the index level will be contained to 5 percent or less while the defensive skew outperforms both growth and cyclicals until rates show some signs of actually bottoming or hard data suggests the recovery will be more robust than we currently expect.” The next chart shows that defensives relative to secular growth remain above the lows from last summer when the Fed cut rates for the first time this cycle and appear to be turning up again as growth concerns perhaps return.
Paradoxically, this means that the Fed’s safety net will prevent a major selloff even if, or rather especially if the coronavirus epidemic results in collapse in economic supply chains and economic devastation. The irony: for stocks to drop, the economy and corporate profits will have to finally bottom and be on a solild uptrend, also known as just another day in the bizarro upside-down world of the “new abnormal.”
Trader Milko Zashev