Our CIO and Chief U.S. Equity Strategist explains why economic fluctuations have made it more difficult to project a possible soft or no landing outcome, and how investors can navigate this continuing market volatility.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the continued uncertainty in economic data and its impact on markets.
It's Monday, June 10th at 11:30am in New York.
So let’s get after it.
Over the past few months, the economic growth data has surprised to the downside with more data releases coming in below expectations than usual. Meanwhile, inflation surprises have skewed more to the upside. This is a challenging combination because it means the Fed can't cut rates yet even though it may make sense to keep the economic expansion going.
As we have been discussing for months, aggressive fiscal spending is keeping the headline economy looking good on the surface. The bad news is that inflation remains too high for the Fed which has to keep interest rate policy too tight for many economic participants. Some may disagree with that statement, but we think it's hard to argue with the yield curve which remains significantly inverted and a valid indicator of interest rate policy. When combined with high price levels for many goods and services, the end result is a crowding out of many parts of the economy and consumers. From our perspective, this is most evident in the persistent underperformance of small cap stocks. In fact, this past week, small cap equities relative performance fell to new cycle lows.
Even more concerning is that while small caps are showing greater interest rate sensitivity than large caps, it’s also asymmetric. While higher rates are an obvious headwind for small caps, we're skeptical that lower rates offer a comparable benefit. Last week was a good example of this dynamic when small caps underperformed early in the week when rates rose and later in the week when rates fell.
All of this argues for what we have been recommending — in an uncertain macro world, we think investors should stay up the quality curve with a barbell of both growth and cyclicals to participate in both the soft and no landing outcomes. We also think it makes sense to have some defensive exposure as a hedge against the above average risk of a recession that still looms. Given the more negative skew in the economic surprise data as noted, we think the defensive part of the portfolio should outweigh cyclicals at this point. We favor staples and utilities specifically in this regard.
With markets sensitive to unpredictable inflation and labor data, it's very difficult to have an edge going into these releases, particularly on the labor front where the data itself has been subject to significant and ongoing revisions. While many market participants focus on the non-farm payroll data, these data have been subject to some of the larger revisions we’ve seen in recent history. Meanwhile, the household survey has been weaker than the non-farm payroll data and job openings have fallen persistently over the last 18 months. These diverging labor dynamics are classic late cycle phenomena based on our experience. For investors, it's just another reason to stay up the quality curve and to avoid positioning for a broadening out to lower quality areas. In our view, such a broadening is unlikely in any kind of sustainable way until the Fed cuts meaningfully — and by that we mean several hundred basis points rather than the one-to-two cuts that are now priced into the markets for this year.
Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.
