The US is going through one of its most turbulent economic phases in history and while it, technically, is in a state of recession with consecutive quarters of negative GDP growth, Andrew Sheets, chief cross-asset strategist, Morgan Stanley, believes that the world's biggest economy will go through a mild recession. An inverted yield curve indicates that the market believes the Fed has been aggressive about its rate hikes and would, possibly, enter a pause mode. He expects the economy to change its contours with the services sector making up for the slowdown in the manufacturing sector. But that would leave the US markets vulnerable to earnings downgrades as Sheets believes the market is better at converting product sales into earnings rather than services.
In your opinion, has the Fed done a good job at containing inflation?
I think so. In August, the Fed fund rate was 2.5%, and today it is at 4.5%. In four months, we have moved 200 bps. As an investment analyst the two market indicators suggest the Fed is not behind. First, an inverted yield curve suggests that the Fed might, actually, cut rates over the next two to three years, which is an indication that the market believes the Fed has been rather aggressive about hiking rates. Second, inflation expectation measures have been coming down over the past couple of months.
At what point will the Fed pause?
Our view is that the Fed will hike another 25 basis points on February 1, but it won't indicate at the meeting that this would be the last hike either. But by the next meeting in March, in all probability, we might see growth slowing down and inflation coming off further. Though a further rate hike in March is unlikely, the Fed narrative would be that it is open to hiking rates further but would want to get a better sense of the impact of the cumulative hikes thus far on the economy. By May, growth and inflation would have slowed down even more, and that might be the time when the Fed decides to pause again. Most academic literature suggests that the hikes aren't really felt by the economy for six to 12 months after they occur. We've just seen the fastest rate hike spree over a 12-month period since 1981. So, I think the Fed would rightfully be cautious about the economic impact. Our view is that the US economy will eventually slow down but it may not be recessionary.
Some observers, such as Dr Druckenmiller, believe that inflation will meaningfully come down only when the Fed rate is higher than the inflation rate. Do you subscribe to that view?
It's a good question. That's a very fair and understandable conclusion to reach based on the historical data because if you look back at the Fed hiking cycle since the 1980s, usually, the central bank takes the rate above the core inflation rate before it stops. But that is not happening this time. In some ways, it would be close, or it wouldn't look as extreme...
Why will the Fed not do it this time around?
The reason is because we expect inflation to fall hard next year as growth slows down because of the delayed impact of rate hikes. The year-on-year effect on inflation will push the rate of change down. We will also see a large swing in pricing dynamics within the goods side of the economy as consumption of physical goods, which has been unusually high, weakens.
In terms of the rate transmission, which part of the economy will be impacted first? Will it be consumption or manufacturing?
The transmission would first show up in the housing market first and last in the labour market. The big rise in mortgage rates means housing transactions could fall very sharply to levels last seen during the financial crisis. That matters because when fewer homes are sold it will reflect in the GDP as well because, usually, moving to a new home involves purchase of goods such as furniture, electronics and so forth. Fewer people moving homes will result in lower big-ticket goods purchases. That's one reason why we believe goods consumption will slow down. We also expect lower residential investment as fewer homes will get built owing to higher financing cost. Finally, the impact of the rate hike will be visible very late in the labour market as we expect wage growth to remain high even after the Fed hits the pause button. In fact, it is quite normal for wage growth to peak out late in an economic cycle as we have seen a similar trend play out historically.
Technically, two quarters of lower growth means that the US is already in recession. So, does that mean, this time around, the slowdown will play out differently?
We expect services consumption will pick up a bit and that will, ultimately, result in a positive overall consumption cycle but at a much slower rate than before. We may see GDP growing by about 0.3% in 2023, thus the US will kind of avoid a recession. But the shift from goods to services is important and that's also a reason why we are below consensus for our earnings expectations for the US stock market next year. We expect US earnings will be hurt both by a slower rate of nominal GDP and, also, because the stock market is much better at converting the sale of physical goods into earnings rather than the sale of services. If a customer spends $200 on a television, that effect shows up in the equity earnings than $200 spent at the dentist or at a concert or at a restaurant. The market is much better at converting the sale of a barbecue or the sale of an iPhone or iPad into earnings than converting a dental visit into earnings. Hence, though the spend is the exact same while computing the GDP, not every dollar spent will reflect in earnings estimates.
Does that mean we will see a disconnect between GDP growth and the market?
Yes, we will have real GDP growing at 0.3% but S&P 500 earnings declining by about 10% or over 10%.
How long will this disconnect last?
As earnings expectations increasingly get muted, we expect more downside to the US equity market before things get better. The downside could play out in the first quarter of 2023, and that would drive another leg lower in the equity market before things start looking better. The pain being over for equities will be linked to signs of fear or capitulation. Capitulation among equity analysts would mean a drastic cut in earnings estimates. As far as investors are concerned, the fear or capitulation would manifest as extreme outflows or negative survey readings.
So, what does that mean for investors?
Over the next 12 months, even as the US and Europe slow down sharply, China's growth will accelerate and broader emerging markets will do better. Hence, we are overweight on emerging market equities and debt. We think those asset classes will perform better than their developed market counterparts. However, high-rated bonds in the developed market will do well. We might see a dynamic situation wherein the Fed and the ECB will stop raising rates and that will create a friendlier environment for the bond market. As a result, investment grade corporate bonds in Europe and the US will do well amid lower inflation. But investors will have to be more patient about US equities as there is more downside in store.
Won't higher interest rates also impact flows into US equities?
It's a good question. So far, we have seen those flows slow down a little, but they have not stopped. It's the right question to ask because the S&P 500 has a dividend yield of 1.6-1.7% whereas a three-month US Treasury bill is yielding 4.2%. Today, it makes more sense to own a T-bill versus the S&P 500.
If equities are still seeing inflows does that mean that the rate hike transmission is yet to be felt in banking accounts?
Yes, that's because the US banks are, generally, slower to adjust their savings rates than the market. So, the average savings rate on a bank account isn't providing as much direct incentive to the depositor. But you're absolutely right, going forward, holding short-term bonds, treasury bills will look increasingly attractive relative to holding cash in the bank and staying invested in the market. As a result, we will see a reversal of the trend in the US wherein, historically, households held a higher share of equities and a lower share of bonds relative to their overall wealth.
Does that also mean the worst is over for bonds, which went through a pincer last year?
Bonds suffered the largest price losses — in 40 years — in the US. The losses occurred because the price had to be taken down to raise what the bonds will yield in the future. Now, with yields up and prices down, the future returns look a lot better. Similarly, in the stock market, returns are more unpredictable than bond returns as a lot more variables are involved. The US or other global equity markets which, historically, enjoyed higher multiples are now trading at valuations which indicate average forward returns. But bonds will do well over the next 12 months as we are forecasting about 4% yield for US treasuries.
If bonds are going to do well what is the ideal portfolio allocation an investor should look at?
Bonds are worth having in a portfolio as they provide both yield and diversification. We expect bond volatility will come down and that should be helpful. So, from a portfolio perspective, we would rather be overweight bonds than overweight stocks.
What does this mean for the dollar and its impact on commodities?
We are forecasting the DXY index to move sideways over the next year. A month ago, we had a target of 104 on the index and that forecast implied that the dollar would be lower. Now given the drop in the dollar, the dollar will move sideways because it still pays an investor well — over 4% — and that matters. Hence, it's tough to short the dollar because it's still remunerative for investors to stay invested in.
What's the outlook for commodities?
We're forecasting oil prices to move higher over the next 12 months as China reopens its economy. Our economists are bullish about growth in India as well, and that means more demand for crude. Given that investment in production of oil has been low, prices will move higher over the next 12 months to $105-$110 a barrel. We're forecasting gold prices to be roughly at similar levels, maybe a little bit lower as it has performed very well relative to the level of yields over the past one year.
Is a high-rate environment good for securitised products as well?
Securitised products offer investors lower liquidity but at the same time these bonds often have a bit of economic protection because you would need a very, very bad economic outlook to cause losses. Since we don't expect a grim economic outlook, we're favourable, for example, towards AAA bonds backed by auto loans in the US. The spreads on these products versus T-bill yields look fair as they have tightened over the past month and a half. So, for many of these higher-rated bonds, the spreads will continue at current levels and, hence, make it lucrative for an investor.
What would make you nervous in the New Year?
2022 reminded us that inflation is very hard to forecast and, so, we think inflation will come down more than what most investors expect. But there is a big uncertainty here. If inflation does not come down because the price of housing remains very high, that creates a dilemma for the Fed on whether they should keep hiking rates. There is also genuine uncertainty around the tightness in the labour market and again this is something that the Fed is concerned about. While there is historical evidence to show that wage growth is one of the last economic indicators to roll over, it may be a little bit different this time around. Maybe the labour market is genuinely a lot tighter this time around not just in the US but also in the UK and the Eurozone. That means not only will inflation stay higher but corporate margins will also come under more pressure. In such a scenario, the Fed will have to be more aggressive and keep rates higher longer than we expect. If that happens, yields will trend higher and, in turn, not only will equities flounder but bonds will do worse.
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