Morgan Stanley
  • Thoughts on the Market Podcast
  • Jun 14, 2021

A View from the Peak?

With Mike Wilson
U.S. Equities Research for Investors


Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace.

It's Monday, June 14th, at 11:30 a.m. in New York. So let's get after it.

Last week's much anticipated release of May's Consumer Price Index turned out to be higher than expected. However, both Nominal and Real 10-Year Treasury yields fell. While this market reaction may have surprised investors, there are plenty of reasons to explain it. First, as noted in our recent research, inflation has been the most discussed topic with clients for weeks. Second, Treasury Inflation Protected Securities, or TIPS, have become very crowded, especially in the retail community. Third, the actual pricing of future inflation is already reflecting a bullish outlook with most tenures reaching 10 year highs. And finally, both corporate and consumer surveys suggest expectations about inflation have changed, too. This is important because expectations can lead to behavioral changes that make inflation more persistent.

While all these measures have moved up sharply, they also appear to have peaked from a rate of change standpoint with the shorter tenures of the inflation expectations market rolling over. The point here is that just like many of our growth measures, it appears that the peak rate of change for inflation may be behind us, too. And, this is why Treasury yields have recently rolled over. It also means that both growth and inflation may disappoint what are now lofty expectations, and that would have negative consequences for stocks more broadly. The main culprit for such a disappointment is the first quarter level of demand that was aided by a $1.9T fiscal stimulus and a rise in crypto currencies that added nearly $1T to wealth. Neither of these are likely to be repeated in our view; and in the case of crypto, there's been a $1T reduction of wealth in the past month that could have a negative effect on demand going forward.

While we continue to think growth and inflation will be quite strong over the next year, the peak rate of change can present short term headwinds for popular trades. The Treasury market is an example, but it's not the only warning sign. Some of the more cyclical equity sectors, especially early cycle ones like autos, home builders and home improvement, retailers, semiconductors and transports have also started to underperform.

In addition to these market signals that growth and inflation may be peaking, we see limited upside ahead for broad earnings revisions from here, too. We worry too many investors may be annualizing abnormally strong Q1 results modelling even further margin expansion from already elevated levels. In addition to the unrepeatable fiscal stimulus and crypto surge experienced during Q1, expenses are ramping up again as businesses reopen and resume normal operations. However, consensus net profit margin expectations for 2022 sit roughly 100 basis points above all time prior peaks. With rising costs and taxes combined with a slowing rate of change on growth, stimulus, and monetary easing, we think these profitability expectations are at risk.

Our analysis suggests several sectors in particular stand out as outliers on margin expansion relative to sales gains. Many of these fall into the early cycle moniker already mentioned. Therefore, we recommend avoiding these areas for now and position one's portfolio toward higher quality sectors and stocks where expectations and valuations are more achievable and modest. Healthcare, REITs and Consumer Staples fit that bill.

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While the outlook for growth and inflation looks strong through next year, both may disappoint lofty investor expectations—and bring consequences for some stock sectors.

Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.

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