Mike Wilson: Disinflation and Equities

While falling inflation is good news for many, equity investors may see volatility in earnings growth as pricing power fades.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 17th at 11 a.m. in New York. So let's get after it. 

Last week was all about the downward surprise to the June inflation data. More specifically, both the consumer and producer price indices came in well below expectations and suggests the Fed is on its way to winning its hard fought battle to beat inflation back down to 2%. Both stocks and bonds celebrated the news as a likelihood for a soft landing and the economy increased. Our view is not so sanguine on stocks as the steeper fall in inflation supports our view for a much weaker than expected earnings growth. 

Three years ago, at the trough of the pandemic recession, we were a lonely voice on the idea that inflation would surge higher due to excessive fiscal and monetary support. Furthermore, we suggested it would lead to a surge in earnings growth as companies discovered an ability to raise prices at will while the government subsidized labor costs. As we move to 2021, this over-earning broadens out as consumers spent their excess savings on everything from sporting goods to travel and leisure activities. By last summer, this boom in spending was so strong the Fed was forced to raise interest rates at a pace not seen in 40 years. With a lag in monetary policy close to 12 months, it should be no surprise that we are now seeing the headwinds on growth and inflation today. 

Because markets are forward looking, they understand this dynamic perhaps better than the average investor. In fact, it is the primary reason we decided to get tactically bullish on U.S. stocks last October. At that time, we suggested long term interest rates in the U.S. dollar would top in anticipation of the Fed's aggressive policy having its desired effect on inflation and growth. That began to play out in the fourth quarter as price earnings multiples expanded from 15.3x in October to 18x in early December. We decided to take the money and run at that point, thinking the market had already fully discounted the peak in inflation interest rates in the US dollar. Over the next six months, 18x did provide a ceiling on valuations. However, over the last six weeks, valuations have risen another 10% as the inflation data confirmed what we already knew. Meanwhile, artificial intelligence has given investors something to get excited about, but at unattractive valuations in our view. 

As noted earlier, we think inflation is now likely to surprise in the downside. A move to disinflation is positive for stocks because valuations typically rise under those circumstances. However, that has already happened. Now we expect disinflation to shift to deflation in many parts of the economy, in other words,prices began to fall. Most are not forecasting such a decline because it seems hard to fathom after what they witnessed in the real economy. However, it's just the mirror image of what happened in 2020 and 21 when supply was short of demand. At that time, inflation surprised companies and investors to the upside and led to much better earnings growth than forecasted. Now pricing power is fading due to demand falling short of supply, and this is likely to surprise many companies and investors to the downside. More importantly, it's not expected by the consensus anymore or is it in stock valuations at this point. 

We are already seeing pricing come down in many areas like consumer goods and commodities. Housing and cars are also seeing price degradation, especially in electric vehicles where supplies now overwhelming demand. In the latest consumer price index released last week, we even saw deflation in both airlines and hotel prices, two areas where demand is still robust. The bottom line, while falling inflation last week was great news for the Fed and its war on higher prices, equity investors should be careful what they wish for, as this is a slippery slope for earnings growth and hence stock valuations which are now quite extended. 

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