Morgan Stanley
  • Thoughts on the Market
  • Sep 21, 2020

A Correction with Policy Roots

With Mike Wilson
U.S. Equities Research for Investors

Action by Congress and the Fed, and its absence, has paved the way for the recent downturn in equities, putting markets back on a more sustainable footing. Chief Investment Officer Mike Wilson explains.

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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Current Episode Transcript

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, September 21st, at 11:30 a.m. in New York. So let's get after it.

September hasn't been very nice so far, with equity markets down about 10% from recent highs and many of the favorite tech stocks down more than 20%. Part of this recent correction is simply due to the run up we saw in August driven by speculation from inexperienced retail investors. Therefore, a better way to think about it is that we're just back to where we were prior to that move higher, that probably shouldn't have happened in the first place. Furthermore, bull markets experience corrections along the way, and that's exactly what's going on now in our view.

That's not to say such corrections can't shake investor confidence, especially when they happen so quickly and are surrounded by emotionally charged events like a global pandemic, a recession, and a presidential election. For those looking for more specific reasons for the declines last week and this morning, I would say two.

First, it looks like Congress is having a difficult time coming to terms on the next round of fiscal stimulus. It's not that either side is unwilling to spend more money, it's how much and where does it go. What that really means is both sides want to make sure they get credit from voters in November. But markets are impatient and are likely to exert pressure on Congress to get the deal over the goal line, which may take a few more weeks. The unfortunate and unexpected passing of Supreme Court Justice Ginsburg is also likely to further cloud this ongoing negotiation.

Second is the Fed. When the recession hit back in March, the Fed reacted swiftly and decisively. Never before has the Fed moved so aggressively to shore up financial markets to ensure capital could flow where it was needed the most. They have stood tall in support of whatever Congress decides to spend to support the economy during this. However, in the past few months, the Fed has changed its strategy in terms of exactly how it will support the recovery going forward, and that has come as a bit of a surprise to markets. More specifically, the Fed's commitment to keeping short term interest rates near zero for as far as the eye can see is clear. They have moved to what is called an "average inflation targeting" regime. What that means is that the Fed will not raise interest rates even as inflation rises above its 2% goal-- something they haven't been able to sustainably achieve since the Great Financial Crisis. However, what they have not committed to is keeping longer term interest rates lower via Treasury bond purchases. And last week they reaffirmed that stance and made it even clearer by not providing any definitive guidance in its quantitative easing program. Why does this matter?

Long term Treasury yields are at a discount rate for all longer duration financial assets in the world. By all accounts, 10-year Treasury yields are well below what I would call fair value. Every other metric we look at that typically mirrors ten-year yields has moved materially higher since March. There's only one reason these rates are still low: the view that the Fed wants to keep them low. But now they aren't saying that. And so the risk reward of owning financial assets that are dependent on these rates staying low is increased. While all equities are long duration assets depending on ten-year yields, expensive growth stocks with cash flows further out in the future are the most vulnerable to rising back end rates. Compounding that risk is the fact that many of these stocks became overpriced in August on the view that long term rates were never going higher. This is why the Nasdaq has underperformed so much in this recent correction and is likely to continue until the stocks reflect this risk of higher long term rates. I estimate that's another 10% downside from here for major equity markets and perhaps 15% for the Nasdaq.

Ultimately, this will be a buying opportunity for those who have cash or those who missed the first powerful leg of this new bull market. We continue to focus on those companies that can deliver better than expected earnings growth next year. This includes a mix of companies most levered to the reopening of the economy and a select group of growth stocks once they better reflect the risk of higher rates.

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people to find the show.

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