In a note release by Morgan Stanley strategist Andrew Sheet, he expects a sharp slowdown for the US economy, along with a pick-up in global inflation that will keep monetary tightening intact, urging clients to get out of credit, load up on emerging markets and stock up on cash. In short, while 2018 was defined by “rolling bear markets”, 2019 will be the year of “turning.”
Additionally, Sheets writes that last year’s ‘tricky handoff’ of slower growth, higher inflation and tighter policy continues, and is now joined by key shifts in the relative trend of growth and policy. These macro shifts will mean turning points in five key market
relationships, and as Morgan Stanley explains, it differs from the consensus when it comes to: USD weakens, US and EU rates converge, EM outperforms, US stocks underperform, value beats growth, EM sovereigns outperform US HY.
Summarizing the bank’s key cross-asset views for the coming year, they are one where
- Macro turning points: The world still faces slower growth, higher inflation and tighter policy. But 2019 should see a turning point in this narrative, specifically in US growth, inflation and policy relative to the rest of the world.
- Market reversals: Turning point in macro coupled with extreme pricing means we expect: 1) US and European yields to converge. 2) USD to make a cyclical peak. 3) EM assets to outperform. 4) US equities and high yield to underperform. 5) Value to outperform growth.
- Where we differ: We think our calls for USD weakness, UST outperformance, US equity underperformance, value > growth and EM vs. US credit are non-consensus, materially different from market pricing, or both.
- Strategy implications: We remain neutral equities (+0%), underweight credit (-5%), neutral government bonds (+1%) and overweight cash (+4%). Within this defensive posture, we are taking larger relative positions, and adding to EM.
While the note is quite bearish on the US, where growth is seen slowing to an annualized rate of just 1% by the third quarter of 2019, it is also a glowing praise of stocks outside the U.S. which the bank expects to do better than their American peers.
In a nutshell the bank’s 2019 global macro outlook is that this will be a year in which EMs “retake the lead” as a result of:
- Global growth slows towards trend
- US/DMs slow
- Fed pauses/dollar weakens
- China easing works
- Growth differentials move in EMs’ favour
Meanwhile, as the Fed pauses its rate hikes in Mid-2019 offering emerging markets a break from the pressure posed by Treasury-yield and dollar gains this year, Sheets predicts that China’s easing measures will finally kick in…
… providing a much needed boost to EM markets, even as risks are skewed to the downside due to i) US corporate credit; ii) trade tensions; iii) continued USD strength and iv) growing political risks.
While hardly a surprise, Morgan Stanley also notes that 2019 is also the year when QE turns decisively into QT. While the Federal Reserve’s balance sheet has shrunk this year, those of Japan and Europe still grew meaningfully. In 2019, the full G3 central bank balance sheet declines.
As the US economy slows, Morgan Stanley notes that this narrowing of US versus RoW growth differentials leads to a narrowing of policy differentials.
As a result, Morgan Stanley believes that the Federal Reserve will eventually adjust to the weaker growth outlook, pausing after two hikes in March and June. The ECB and BoE, in contrast, will sound increasingly committed to tightening (relative to market expectations), as eurozone growth bounces back from a temporary 3Q18 soft patch, and the UK faces higher inflation in a variety of Brexit scenarios, according to the bank.
That said, and echoing recent comments from Nomura’s Charlie McElligott, Sheets says that he doesn’t think that a ‘pause’ in the Fed hiking cycle is a boon for US assets, “at least not for now.” Before pausing, the Fed will likely sound determined to keep tightening policy, given still-easy financial conditions, rising inflation and a tight job market.
As a result, the bank thinks that a major challenge for US assets next year is that they’re ‘boxed in’ as “better-than-expected growth will simply mean more Fed tightening, while weaker-than-expected growth will raise slowdown risks, with limited scope for policy support.”
In an assessment that promises to create more headaches for traders, the bank predicts that “in a major change from the last 10 years, both good news and bad news create problems for US markets.”
Focusing again on the US, and what many believes will be the catalyst for the next crisis, namely credit, Morgan Stanley reminds its clients that the credit bear market started when IG spread hit the tights in February 2018. The resulting selloff is a renormalization as real rates continue to rise, offering a far broader menu of investments for yield-chasing investors.
The bank then asks rhetorically, how many “idiosyncratic” problems do we need to see before concluding that the issues are not one-off?
Shifting away from Credit and to FX, the bank predicts that underperformance of US growth leading to relatively less tightening from the Fed should drive broad-based USD weakness, especially given its expensive starting point.
We think that this weakness is broad-based, with both DM and EM currencies gaining. Our most controversial assertion is EUR strength, a direct function of our expectations for better relative growth, more relative hawkishness and positive political surprises versus the US next year.
With the broad trade-weighted dollar less than 1.1% from its 2017 peak, and dollar sentiment unusually bullish, the set-up looks ripe for reversal as the market struggles to add more hikes into the expected Fed path.
This is generally bad news for US stocks, which tend to underperform when the US Dollar weakens.
Even so, don’t expect much more downside to US stocks because as of Q4, US stock valuations now compensate “to a significant degree” for the risks which are out there.
That said, growth stocks remain expensive to value on a worldwide basis.
Commenting on these expected rotations, Morgan Stanley writes that within global equities, it sees a strong case to favor RoW over the US, with Japan and EM leading Europe within RoW, while value will outperform growth.
US equities, which face the sharpest deceleration in GDP and EPS growth, and the greatest valuation pressure from rates, move to an underweight. In addition to a turning point in RoW versus the US, we see a turning point for value over growth, with value supported by extreme relative valuations and better estimate achievability in all four major regions.
Finally. while the bank sees a 60% probability of its “ditch the US” scenario materializing, it has also forecast bull and bear cases which represent 20% scenarios on either side:
- Bull case – no growth slowdown: Growth in Asia and Europe bounces back more strongly after a weak 2018, and the US shows signs that rising productivity could extend the cycle greatly. In such a scenario, central banks are able to tighten more aggressively, driven by a desire to reclaim policy tools ahead of the next downturn. Also falling under this scenario is a secondary bull case where growth doesn’t bounce back as strongly, but we overestimate the willingness of central banks, especially the Fed, to tighten policy.
- Bear case – a US recession: the bank puts the chance of a US recession at ~20% for 2019, and while such a recession would be mild, we do not think that it is close to being expected, or in the price for markets. The largest implication would be for the fed funds rate, which falls to 0.125% by end-2020 in this scenario. While initially extreme, we think that such a cut is actually quite possible, given that a large deficit means that the US will lack the usual fiscal tools. The result would be much lower yields, a significantly weaker USD and the worst returns for US HY credit since 2008.
The SPDR S&P 500 ETF Trust (SPY) was trading at $266.87 per share on Monday morning, up $3.62 (+1.38%). Year-to-date, SPY has gained 0.40%.
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