Our Insights

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. 

Is the end of this equity market correction in sight? Today on the podcast, I’ll share what I think could turn the tide.

It's Monday, October 26^th at 11:30 am in New York.  

So, let’s get after it.

The correction that began in June is now well advanced beneath the surface. But I believe  the high-quality S&P 500 index may still have some unfinished business. Until that plays out, I don’t think we can say the adjustment is complete.

The real question to ask: how bad does it have to get before it gets better?

We have described this correction as a classic mid-cycle transition. The peak rate of change in earnings revisions arrived right on schedule, about a year after the recession troughed. And the market responded the way that it usually does: early-cycle leaders with more operating and financial leverage started to underperform, while higher-quality, asset-light, services-oriented businesses moved to the front.

This quality rotation is now well understood though, and positioning has followed it.  Ironically, the final step is usually a convergence between the resilient high quality S&P 500 index and the weaker breadth beneath. We may already be seeing the beginning of that meeting in the middle. If the index does move lower, I believe 7100-7200 on the S&P 500 is where the correction should find material support.

The reason I believe we will ultimately have a positive resolution to this transition is that a lot of damage has already occurred. Roughly 60 percent of Russell 3000 stocks are down more than 20 percent since June. And the hit has been even more severe in early-cycle areas like Semiconductors, Autos, Consumer Cyclicals, and Capital Goods.

At the same time, hedge-fund positioning has come down meaningfully leaving us near the lows for the past 12 months. That is encouraging, but sentiment overall is not yet at the kind of extreme that typically marks a durable low. I think we are close but we’re not quite there.

So, what gets us there? I see three clearing events ahead.

The first is AI. Investors are questioning the eventual return on capital, the cost of capital, and whether credit markets can fund all the spending that has been promised. Over the next few weeks, the market will need to absorb more supply, and lower-quality players may continue to see wider spreads and even lower stock prices.

I view the supply as the event itself. Once it clears, the risk should begin to fade. Semiconductors remain at the center of this concern, and may offer a good benchmark to monitor for the broader market correction.  Specifically, I see another 10 to 15 percent lower for the Semiconductor index into mid-November.

The second clearing event is the midterm elections. Markets dislike uncertainty, and this election has plenty. A blue wave is not a surprise anymore though.  The larger overhang is what may happen after the vote, including the possibility of a renewed military escalation in Iran.

I have no special edge in forecasting geopolitics. But I do know that these kinds of shocks often create very good buying opportunities. Historically, post-midterm returns have been very strong, so I would be ready to embrace a sharp downdraft in stocks in the days and weeks around election day.

The third, and most important, clearing event is liquidity. Financial conditions have tightened sharply through a combination of higher rates, slower balance-sheet growth, stronger demand for capital, and higher energy prices.

The tightening is beginning to resemble 2018, and it is not far from what we experienced in 2022 despite very modest tightening from the Fed so far. In fact, the market may be doing the Fed’s tightening for it; and if that tightening begins to create funding stress or destabilizes credit markets, the Fed and Treasury have tools to respond. The question is whether conditions need to deteriorate further before they act.

Bottom line, I think the correction in equity markets that began in June is in the final stages, but the final stage can be very uncomfortable. We may still need one more index-level drawdown and bout of volatility. Or one more moment when investors conclude that something has broken. That may be exactly what clears the path for the Fed to pivot and the next leg higher for stocks.

For now, I want to stay with quality stocks that have already corrected more than the index in areas like capital goods. More importantly, if these clearing events create a sharp downdraft, I would view it less as a reason to run from risk and more as the opportunity we have been waiting for to buy.  So be ready.

Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!

Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist and Head of Macro Research. 

Michael Gapen: I'm Michael Gapen, Chief U.S. Economist. 

Jens Eisenschmidt: I'm Jens Eisenschmidt, Chief Europe Economist.

Chetan Ahya: And I’m Chetan Ahya, Chief Asia Economist. 

Seth Carpenter: Yesterday, we talked about why global growth is continuing to power on, why investment is playing a larger role, and how that investment cycle is spreading across regions.

Today, we're going to take a deeper dive and think about monetary policy and what's going on.

It's Friday, October 23^rd, at 10 am New York.

Jens Eisenschmidt: 4pm in Frankfurt.

Chetan Ahya: And 10pm in Hong Kong.

Seth Carpenter: When I look around the world and think about especially developed market central banks, well, they're kind of all tightening at the same time – but maybe for somewhat different reasons. 

Let's start with just a really broad policy question. Why are the Fed, the ECB, the Bank of England, and the Bank of Japan all tightening policy when their economies look so different? 

Mike, I'm going to start with you back here in the U.S. with the Fed. How are you thinking about what the Fed is doing right now?

Are they just recalibrating the stance of policy? Or is this a fundamental change where they're trying to rein in growth in the economy? 

Michael Gapen: The way I look at it is this is a story about persistent inflation, and I would look at it as a recalibration of policy. I think the majority of participants on the FOMC know the Fed can't pump more oil or get, you know, oil through the Strait of Hormuz. So, it's about leaning against second-round effects. 

Inflation is gradually moving lower. They've characterized this as dissatisfaction with the speed of convergence to the target. 

So, I think the Fed is tightening based on persistent inflation, and it appears to me to be more about a recalibration than it is about meaningfully tightening policy and leaning into demand. 

Seth Carpenter: All right, Jens. Same question coming to you, and I have to say the energy shock is a global shock. So how do you think about what's going on with the tightening of the ECB and the Bank of England? 

Jens Eisenschmidt: Yeah. No, I mean, first of all, if you sort of talk about both central banks – and here again, I guess the Fed comparison also matters. The starting point is important. The ECB was the only central bank that got inflation back to target, and so was already well advanced in its sort of rate normalization cycle, had cut back rates to 2 percent – which by most measures is sort of neutral, maybe leaning a little bit towards expansionary side of things. 

And so, it was probably easiest for that central bank, when the supply shock came to tighten again, simply by getting a little bit towards the restrictive end of the neutral range, say. I think that is probably what has happened here, more than anything else.

And for the Bank of England, of course, the discussion is a different one. They were running for a long time a relatively restrictive monetary policy. And so there was more scope to wait it out, essentially. A little bit like the Fed, essentially. This is where the similarities come in. 

Now, if you look ahead, essentially, it becomes a question of how strong is your economy holding up? And, you know, the strength of that holding up in the face of a certain given energy shock will determine how much of the inflation that you experience today will be inflation of tomorrow, carried to the next period through stronger wage agreements. 

I think that's basically the policy problem facing both central banks here. And I guess that in the end results in essentially a resolve to at least gradually further tighten the stance. I think that has to be the expectation. And so, from that perspective, this is where we arrive at essentially a current positioning that is not super hawkish, if you think about it.

So, it's not like we have to gung ho every sequential meeting increase rates. But we see a gradual increase in rates. And so, for instance, for the ECB, we have a meeting around the corner next week. We don't think there will be an increase. But the risks have sort of stacked up and are really to the upside for inflation.

So, it will be very hard to avoid a tightening for the ECB in the December meeting. So that's the gradual pace I was just referring to. 

Seth Carpenter: Got it. Ok, Chetan, the developed market central bank in Asia that most people are staring at is the Bank of Japan. So big change there. 25 years of essentially stagnant nominal in GDP growth to now we're on a clear hiking path. 

How far do you think the Bank of Japan is likely to go? What's driving it? And how important is this global energy shock to the Bank of Japan's plans?

Chetan Ahya:  We expect the BOJ to hike its policy rate twice, first in December and then again in March next year. This compares with market pricing of three more rate hikes. So, what explains our dovish forecast? Well, we think that Japan's inflation has been largely driven by FX weakness and higher commodity prices and not due to demand-side pressures. To elaborate, Japan's real consumption is still one percent below pre-COVID levels. Hence, we think BoJ will avoid taking up more aggressive policy tightening. 

Seth Carpenter: So, Mike, let me come back to you for the U.S. We have seen globally a rise in interest rates. The long end of the curve has sold off everywhere. Some of that is being driven by energy prices. We've seen credit spreads in the U.S. start to widen. 

Some of that's being driven by hyperscaler debt issuance, among other factors. But I guess what's important is when Chair Warsh first took over the helm of the Fed, his characterization of how restrictive monetary policy and financial conditions were – was not particularly forceful, right? He said it's hard-pressed to say that it's uniformly restrictive.

But the world feels a little bit different now than it did when Chair Warsh took over. So how does the Fed need to react to the fact that longer-term interest rates have sold off and that credit spreads are starting to widen? 

Michael Gapen:  Financial conditions have tightened. We would characterize financial conditions as, let's call it moderately restrictive.  

So, I think the Fed needs to look at that and then ask itself essentially, "Where is this inflation coming from? What inflation are we trying to stop?" I don't think there's a tremendous amount of evidence that points to an overheating labor market. Rates have risen, but long-run inflation expectations remain stable.

So, I still think the right answer is to lean against potential second-round effects from the energy price shock. And here, I think that would show up in airfares, apparel, new and used cars, motor vehicles and parts. 

We got some evidence in the September inflation report that these other goods prices were firm. We'll see if that continues, and this is an early sign of energy pass-through into other parts of core. But with financial conditions already moderately restrictive, it doesn't suggest they have a tremendous amount of work to do unless there's evidence that AI spending is broadening out to greater labor demand and higher wages. Then it would be a different story. 

For now, I think a few more rate hikes – we have two more rate hikes penciled in, and 75 basis points of rate hikes in total – is probably where we think the Fed will be going by March of next year. 

Seth Carpenter:

Jens, let me turn that to you as well because rates in Europe have also gone up. And importantly, we've seen spreads for French sovereign debt over German debt widen a lot. So, OAT spreads are pretty high. How much has the tightening in financial conditions done the work of the ECB for it?

And as a result, is that a reason to maybe expect less in the way of rate hiking than what the market has priced in?

Jens Eisenschmidt:  I think that's exactly the debate that I would expect to be raging in the governing council next week. We have already seen indications in the accounts in September that it was brought up.

Since then, it hasn't gotten better.  So, there is tightening. We had seen Philip Lane coming out essentially saying in very simplistic ways, ‘Well, this is AI. This is good for the U.S. It's not so clear it's as good for Europe. But, you know, rates have increased here too, and so we need to be super careful.’ That this is not representing us with much more tightening than we actually can stomach.

So, to your point, indeed, I think the market is pricing too many rate hikes. We have one more at this stage in December, and that's it. 

We have to acknowledge that since we made that change in call, we have seen more inflation and probably also more resiliency than we had thought. So that would push us at the margin to maybe one more in March.

But then again, we have seen the tightening at the long end. If that continues, we may very well end up being right with that call without any need to change it. Again, that has to be closely watched. It will very likely depend on the growth  outlook in the end. 

But yeah, long story short, the market currently prices 3/25. I still think this is too much from the ECB here.

Seth Carpenter: So, Chetan, maybe I’ll wrap up with you because we focused on some of the bigger central banks of the bigger economies. But there are different outcomes across different central banks. Here in the Americas, for example, down south, the Brazilian Central Bank, the BCB, is still easing, albeit gradually. Banxico in Mexico is holding rates, not hiking. 

So, when you think about other central banks, across Asia, like say maybe Korea and India, where we're still seeing some strong domestic growth. Are they conforming to the same stories we've talked about for these major DM central banks? 

Chetan Ahya: Yeah, the situation in Asia is somewhat different. They don't have a big inflation problem, but we are seeing strength in growth coming in because of exports. And so, for most central banks, we are expecting them to take up rate hikes. But those will be more countercyclical in nature.

As such, core inflation, except for Australia and Korea is pretty much in the central bank's comfort zone. And so, we don't expect them to react to higher inflation. But to the extent to which, you know, U.S. rates are going up, growth is strong, most central banks will take up countercyclical rate hikes in the coming quarters.

Seth Carpenter: That's super helpful, and that helps make, I guess, a key observation or theme about what's going on. Inflation is a global phenomenon. We are seeing somewhat resilient growth, and major central banks generally are tightening. But it is not a uniform story in every single place. And so, there are some interesting nuances in all of the details here. 

That point also means that the endpoint for hiking cycles at different central banks might not be fully synchronized either. And it will depend, I suspect, in different jurisdictions on the specific evidence that each central bank is looking at – be it inflation itself, wage dynamics, what's going on in labor markets, domestic demand, foreign demand, external demand for exports, depending on the economy. And of course, as we touched on a bit, what's going on in financial conditions.

Well, Mike, Jens, Chetan, thank you so much for helping us connect all of those dots. And to the listener, thank you for listening. And if you enjoy this show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or a colleague today.