Morgan Stanley: “Don’t Get Carried Away By A Year-End Rally”

When it comes to year-end market forecasts, there are those like JPM's Marko Kolanovic who are confident that all the bad news are now largely priced in, and that between the favorable outcome from the midterm election and market technicals - primarily in the form of hedge funds lagging their benchmark and scrambling to catch up to the overall market - will push the S&P sharply higher over the next two months. Goldman Sachs is also in this category, expecting the S&P to close the year 70 points higher at 2,850. Then there are those who, like Dennis Gartman, correctly called the early November bounce and has since reversed, now "officially" urging his clients to short the S&P.

Meanwhile, after correctly predicting the October market slump, Morgan Stanley has eased somewhat on its "rolling bear market" bearishness, although in a note released today its chief cross-asset strategist lays out why despite rising calls for bullish, gridlock-driven sentiment, there is little to be actually bullish about  and notes that the bank is "sceptical that gridlock improves the 2019 story meaningfully" as "slower growth, tighter policy and a steady, persistent rise in inflation all lie ahead in the coming year." Sheets also notes that there is a high chance of upside surprises to inflation over the next several months and concludes by warning MS clients to not "get too carried away by a year-end rally."

Here is Sheets' full "Sunday Start" note:

Checks and Balances

The US midterm election results had something for everyone. But I’ll admit to a small sense of relief over what they didn’t include: a major surprise. Election results in the UK and US over the last two years have made it feel mandatory to approach nearly every political prediction with an aggressive level of scepticism. As someone who purports to do analysis for a living, it was nice to see the number-crunchers get this one (mostly) right.

Tuesday’s results have spawned myriad articles on their implications. The simplest is the emergence of a significant ‘check and balance’ within the legislative process. America’s tripartite system of government enables one part to act as a brake on the actions of another. You may like that. You may not. But for markets and news flow, Michael Zezas and the US policy team now expect an effective halt to the Republican legislative agenda, with no further attempts to repeal the Affordable Care Act and no fresh tax cuts, and from the Democratic side of the aisle, little chance of a meaningful infrastructure bill.

That lack of action may not be a bad thing, with political gridlock long considered a happy medium for markets. That certainly seemed to be the initial take, with the Dow surging 545 points on Wednesday. But be careful about extending that framework too far. Important things requiring compromise still need to get done, chief among them funding the government, which our US economists note faces a key deadline on December 7 (even before the newly elected officials arrive in Washington).

Passing budgets over the last two years has not been easy in the US, even with single-party control of both chambers, and it often required compromise on increased spending to get bills over the line. With the US budget deficit projected to hit ~US$970 billion in FY19 (per the CBO), using a spending increase to get this budget passed may be harder, as political divisions have just widened further.

Government borrowing may be one of the factors behind a second ‘check and balance’, this one for markets. Better growth, more borrowing and less dovish Fed commentary have pushed US real rates materially higher over the last two months. We think that this rise in yields contributed to October’s volatility. It hasn’t gone away.

Indeed, US investors increasingly face the prospect that if ‘good’ economic news means higher yields, it may not be so good after all. This is central to my colleague Mike Wilson’s outlook for the S&P 500, which he believes is now sitting firmly in a range of 2650-2800. Below 2650, he sees the market supported by buybacks and more reasonable valuations, as well as potentially lower rates in that scenario. But above 2800, you need to start assuming an equity risk premium below what we saw in January 2018. Given the euphoria at the start of the year (how long ago that seems!), getting back there on a sustainable basis seems unlikely.

What should investors do about these two ‘checks and balances’? I’d focus on three things:

First, optimism over gridlock can help to drive a year-end ‘bounce’. But we’re sceptical that gridlock improves the 2019 story meaningfully. Slower growth, tighter policy and a steady, persistent rise in inflation all lie ahead in the coming year. My colleagues Jeremy Nalewaik and Guneet Dhingra see a high chance of upside surprises to inflation over the next several months. Don’t get too carried away by a year-end rally.

Second, the ‘check’ of interest rates on equity valuations is not operative in most non-US equity markets. Real rates in Europe and Japan still sit near all-time lows, along with very ‘average’ P/Es. The UK equity market has a forward earnings yield of 8.6% against a 10-year real interest rate of minus 1.6%. Large gaps between equity and bond valuations in these ex-US markets leave more room for good news to actually be…good.

Third, conventional wisdom in FX markets holds that the current political backdrop helps USD and hurts European currencies. But given USD’s elevated levels against EUR, GBP and SEK, our FX strategists believe that this thesis is already in the price. In 2019, we think that European politics may have more opportunity to surprise positively (a low bar!) and US politics to surprise negatively, supporting those European currencies. And if we’ve learned one thing from political storylines over the last several years, it’s the surprise that matters.