Authored by Michael Wilson, chief US equity strategist at Morgan Stanley
Over the past few months, equity investors have received a lot of good news. First, the Fed cut interest rates at the end of July. Next, the ECB announced it would restart QE in November, adding €20 billion per month for as long as it deems necessary. Two weeks ago, we saw “significant progress” from the US and China on trade with Phase 1 of a much larger deal, according to White House officials. If that wasn’t enough, the Fed decided to deal with front-end funding market distress by announcing a US$60 billion-per-month balance sheet expansion, and Brexit seems to be reaching a conclusion.
So why hasn’t the S&P 500 been able to definitively break out above July’s highs? We think it’s pretty simple. Growth has disappointed this year, and many leading indicators suggest it will continue to do so, particularly in the US (Exhibit 1). This is precisely why so many central banks are easing and why there are calls for more fiscal stimulus.
The bottom line is that the risk of a global and US recession next year is higher than it’s been, well, since the last recession. Arguments against a recession next year rely on the still-strong US consumer remaining resilient. The counterargument is that the consumer depends on Corporate America for a paycheck, and Corporate America is hurting, with the average company’s earnings shrinking by 5-10% year-to-date. In other words, the probability is rising that companies may need to start cutting back on labor via layoffs instead of just reducing hours worked and slowing the pace of wage gains. While jobless claims haven’t risen yet, if investors wait until that happens, it will be too late to do anything about it. We’ve been skewed defensively in our portfolios for the past year in anticipation of this growing risk, and it’s worked well.
Over the past few weeks, many high-flying growth stocks continued the tumble that began back in July. Software has been hit particularly hard, in line with our advice to avoid expensive growth stocks due to lofty valuations and unrealistic earnings expectations, given the tepid outlook for economic growth and the austere capital spending backdrop.
Until recently, many argued that software companies would be immune to the capital spending slowdown that began last year, but now there’s evidence that some of these companies are seeing a slowdown via pushouts of new billings. While the deceleration in software and other secular growth sectors hasn’t been as severe as in the more industrial segments, these stocks were not priced for any slowdown, which is why the correction has been so severe for some of the most expensive names. As usual valuation does matter, even for momentum growth stocks.
The other recent change in capital markets weighing on secular growth stocks is the newfound discipline on profitability. In my last Sunday Start, I discussed the impact We Company’s failed IPO would have on investors’ willingness to fund unprofitable businesses. This has played out in lower valuations for the worst offenders. I’ve noticed that several of these companies have reported higher-than-expected profitability during 3Q earnings season. I think this represents an effort to avoid the new scrutiny. But higher profits in the short term likely mean less spending and therefore lower growth in the intermediate term, leaving investors in these hyper-growth companies to figure out the right valuation.
The bottom line is that the winds of change are upon us and the long-overdue adjustment process for the most expensive secular growth stocks is under way and will likely continue until valuations become so cheap that they discount a more achievable outcome on growth and profitability and/or the risk of economic recession and lower capex subsides. I don’t think we’re there yet on either score, so we continue to recommend a more defensively oriented equity portfolio in the US with overweights in Consumer Staples and Utilities, while remaining underweight Technology and Consumer Discretionary. We’re also overweight Financials, because at some point either recession risk will abate or we’ll want to look through the recession once it’s inevitable and the consensus view. Finally, given the aggressive stance of central bankers around the world, the yield curve should re-steepen over the next year, no matter what the outcome, supporting bank earnings and stocks. In short, we favor value over growth, but with a defensive rather than cyclical skew on the value side.