View from the (double?) top
Global equity markets have continued to perform strongly in December (~3%) after November’s sharp advance higher.
The MSCI World Net Local Index gained 8.3% last month and the S&P 500 regained all of its losses from the prior three months on the back of easing financial conditions. In particular, the 10-year US Treasury yield has fallen by more than 100 bps from its recent highs, mostly due to a perceived dovish pivot by the Federal Reserve and less coupon issuance than expected from the US Treasury.
Figure 1: The S&P 500 is within 100 points of an all-time high
The “soft-landing” narrative continues to play out, although faster than most expected, with inflation surprising to the downside while the economy is gradually cooling, thus fuelling expectations for a turnaround in monetary policy in Developed Markets in H1 2024.
Figure 2: Since November both inflation and economic data have surprised to the downside, but the latter remains positive
The US job market remains the most important factor in terms of assessing the “soft” versus “hard-landing” outlook, and recent US employment data reinforced our view that a gradual cooling of the economy is under way.
In particular, job openings in the US fell in October to a 28-month low of 8.7 million, from a revised 9.4 million in September, adding to evidence that: i) the labor market is cooling in response to higher interest rates; and ii) the progressive easing in employment conditions would likely bode for a further decline in inflation (see Figure 3).
Figure 3: US job openings rate and core inflation have been following similar trends since Covid
Source: Bloomberg, MSWM Research
Similarly, we saw November US non-farm payrolls showing a labour market that continues to ease but not “fall off a cliff” (see US Economics: November Employment – Not Falling Off A Cliff December 8, 2023). Although the report surprised consensus expectations to the upside, this upside came from government payrolls, whereas private payrolls surprised to the downside. Private payrolls have risen 145K on average over the past three months, and November was softer: i.e. about 113K excluding returning strikers.
We believe a lot of the resilience – or the slow pace in moderation of the job market – is due to the robustness of the services sector in the US. Unlike the manufacturing sector, not only has the services sector not been contracting but also has been on a slight uptrend since the middle of the year - coincident with the slower pace of decline in terms of job creation. This also further supports the “soft-landing” narrative.
Could this rally run further?
The recent rally has removed the upside regarding Morgan Stanley’s forecasts for the S&P 500 and ASX200 for 2024. Most short-term technical indicators are now showing the rally might be stretched, and therefore raises the possibility of a technical correction (see Figure 7).
In addition, valuations, which have been expensive for most of the year, are again back to elevated levels. In particular, the S&P 500 is trading around 19x next year’s earnings.
That said, we continue to believe that for now, liquidity and the concurrent easing Fed stance are the dominant forces in the market and clearly override the concerns around valuations and stretched technical indicators.
As our Chief Investment Officer Michael Wilson recently noted, even deteriorating fundaments are overridden;
“If the CPI does not come in hotter than expected and the Fed doesn't push back, rates can stay well behaved through year end and provide support for equity prices in the context of weak earnings revisions breadth,”
(see US Equity Strategy: Weekly Warm-up: Will The Fed Push Back? December 11, 2023).
Indeed, earnings revisions breadth has remained negative for the S&P 500 and Russell 2000 (meaning more downward than upward revisions regarding 2024) and 4Q23 EPS estimates are currently down ~5% for the S&P 500 since 3Q earnings season began. A move that has been opposite to the rally in US equities (see Figure 5).
Figure 5: A divergence between earnings revisions breadth and returns has opened-up
Source: FactSet, Morgan Stanley Research
In addition to the recent fall in interest rates, current liquidity has also been a key driver of elevated equity valuations. More specifically, the drawdown of the reverse repo facility has continued to help fund the US Treasury's elevated amount of issuance over the past 6 months. The issuance has provided the financing for the fiscal deficit which has been a key factor in the stronger than expected GDP growth this year, especially in the third quarter. With over US$680 billion remaining in the reverse repo facility, that balance should continue to be drawn down towards zero next year and continue to play a supportive role for both US Treasury funding and asset prices.
Figure 6: US liquidity has been rising since March
Going into last week, the key question for investors was whether Chair Powell would push back on the significant loosening of financial conditions over the prior 6 weeks. Not only did he not push back, but his message was also consistent with the notion that the Fed has likely completed hiking this cycle and is likely to begin cutting rates next year. Markets took the change in guidance as an "all clear" sign to increase risk further.
Given that policy rates (both nominal and real) are well into restrictive territory, the Fed likely doesn't want to wait to shift to more accommodative policy until it is too late to achieve a “soft-landing”. This is a bullish outcome for stocks because it means the likelihood of a “soft-landing” outcome has increased if the Fed is going to start focusing more on sustaining growth rather than lowering inflation to its 2% target. That is not to say this dovish shift doesn't increase the risk of inflation reaccelerating at some point. However, with the Fed's balance of risks tilting toward slowing growth from inflation, this shift is welcome news to equity investors, especially given the bond market's reaction to the dovish guidance - i.e. inflation breakevens have remained “well behaved” and bond yields have fallen further as more rate cuts get priced into the market. In other words, the markets seem to be of the view that the Fed isn't making a policy mistake (see US Equity Strategy: Weekly Warm-up: The Fed Gets More Dovish, What’s Next? December 18, 2023).
In short, the combination of cooling inflation and growth dynamics, as well as a robust liquidity environment and a dovish Fed have helped to support valuations and provide a positive offset to these fundamental dynamics. The market may keep reaching new highs in the absence of a strong negative trigger, as the “soft-landing” narrative continues to play out. We see the next big “test” as the all-time high on the S&P 500 - which is currently less than 100 points away. The re-test of an all-time high is a critical test for the market, as investors are often wary of a “double-top” formation. The index breaking through that psychological level could mean further gains until the next earnings season, where the recent equity strength will likely then be tested against Q4 data. A failure to break through could question the recent rally and trigger profit talking.
Given we have seen a concurrent fall in Australian yields with the US, is the Reserve Bank of Australia (RBA) moving closer to becoming dovish?
Recent news flow is mostly supportive for the RBA keeping its holding pattern:
i. Disappointing Q3 GDP: The consumer remains under pressure, with relatively flat spending despite a further fall in the savings rate. Labour costs have accelerated and offset an improvement in productivity (see Australia Macro+: Q3 GDP: Sharper Slowing From a Higher Base December 6, 2023).
ii. Although the unemployment rate rose slightly from 3.8% to 3.9% in November, employment creation was very solid on the month: Employment increased by 62K, much more than Morgan Stanley’s expectation of 15K or consensus at 12K (see Australia Macro+: Labour Force: Strong Demand, Stronger Supply December 14, 2023).
Movements in Australian rates are generally significantly influenced by US rates. With Australian government bond yields down to around 4.1% and discounting more than two rate cuts next year versus Morgan Stanley’s expectation of one rate hike, we believe the market has transposed too much of the current US dynamics into Australia. Wage growth and employment dynamics remain solid and will force the RBA to retain a hawkish bias longer than the market expects. This means that Australian long duration bonds are likely to keep underperforming their US peers for the next 3-6 months.
What are the key data points to follow in the short term?
Job creation remains solid around the world, and even if this data is cooling, the job markets remain tight in the US and Australia, thus supporting a gradual normalization of core inflation.
However, while inflation and the job market continue to point to a gradual deceleration - in turn supporting our “soft landing” scenario - we continue to monitor recession risks, as once again we remain wary of the lagged impact of monetary policy. We believe a recession would likely occur though a sharp deterioration in the job market. US initial jobless claims and layoff plan announcements from the corporate sector at the next earnings season could possibly be the catalyst.
In addition, we note that expectations of exceeding US economy growth forecasts for most of 2024 - which have translated into stronger than expected GDP and higher than expected bond yields - have now started to reverse relatively sharply. Although this reversal has been positive for equities so far - i.e. bad news (the economy is cooling down) is good news (meaning inflation will continue to slow and allow a dovish turn for central banks) - a steep worsening of the trend could potentially reignite recession concerns and thus negatively impact stocks.
Once again we see high quality fixed income – especially government bonds – as a beneficiary in both cases and we continue to build our position within our portfolios. However, we are less bullish in the very short term after the recent rally which has been premised on rate cut expectations. We see limited risk-reward in pushing duration long given the market is pricing around a nearly 90% chance of a rate cut in March.
Investment Implications
It will likely take some time, probably around another 6 months, to get a clear view on the “soft” versus “hard-landing” outcome. Episodes of market volatility are likely if - as we foresee - macro data deteriorating at a time when equities are relatively expensive. However, as long as the “soft-landing” remains in sight - i.e. the weakening in economic data remains gradual and inflation continues to normalise - we recommend using these developments to add to equities.
Similarly the fall in inflation is expected not to be linear, and any temporary adverse outcome, or move higher in the oil price, may bring an attractive entry point for government bonds.
In summary, while the Fed may have pivoted their communication, the path to a successful “soft-landing” of the economy remains a narrow one: the upside risks to inflation and downside risks to growth are significant.
Cross-Asset Positioning
We retain a small Underweight (UW) position in Equities in the short term. Even if we expect a “soft-landing” we remain late cycle and cannot completely dismiss recession risks. However, we have been reducing the size of our UW position to a marginal one and look for opportunities to keep building as long as the “soft-landing” scenario continues to play out. The “quality” style (i.e. low gearing, strong profitability, consistent earnings) remains preferred as a typical late cycle outperformer.
We have an Overweight (OW) to duration via Government Bonds, favouring International over domestic. We have an OW to Investment Grade (IG) Credit with a preference for short duration in the US (and floating rates in Australia) and no allocation to sub-IG bonds.
We like Alternative investments the most in the current environment and are positioning with a mix of gold, hedge funds as well as select private investments to enhance returns, lower portfolio volatility and manage equity beta risk.
Cash is also appropriate at this point given higher yields versus long bonds, and range trading markets.
Figure 7: Equity momentum and breadth heatmap
Source: Bloomberg, DataStream, MSWM Research. Data as at December 15, 2023.
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Alexandre is the Head of Research and Investment Strategy for Morgan Stanley Wealth Management Australia.
Since arriving at Morgan Stanley, he has developed Wealth Management’s multi-asset investment approach which was recognized by the Institute of Managed Account Professionals (IMAP) as the winner in the 2020 and 2021 Licensee Managed Account category, and the 2021Multi Asset Class category.
Alexandre is primarily responsible for producing investment strategy research and providing implementation advice across listed Equities, Managed Funds and ETFs to Morgan Stanley's advisors and their clients.
Alexandre has more than 15 years of investment management experience, in both wealth and institutional money management.
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Alexandre is the Head of Research and Investment Strategy for Morgan Stanley Wealth Management Australia. Since arriving at Morgan Stanley, he has developed Wealth Management’s multi-asset investment approach which was recognized by the Institute...
Expertise
Alexandre is the Head of Research and Investment Strategy for Morgan Stanley Wealth Management Australia. Since arriving at Morgan Stanley, he has developed Wealth Management’s multi-asset investment approach which was recognized by the Institute...
Expertise
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