Mike Wilson: Fire & Ice Continues Into Year-end

Our narrative of tightening monetary policy and decelerating growth continues to play out amidst developments in Omicron, failed legislation and signals from the Fed.

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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, December 20th at 11:30 a.m. in New York. So let's get after it.

Our Fire and Ice narrative for tightening monetary policy and decelerating growth is playing out, with the central banks taking aggressive steps to deal with the higher-than-expected inflation. Meanwhile, Omicron and the failure to pass President Biden's Build Back Better bill have awakened investors to the risk of slower growth that we think is as much about the ongoing cyclical downturn as these external shocks. In short, stay defensive with your equity positioning.

First, with the Fed preparing investors over the past four months for what could be a very long process of removing monetary accommodation from markets that have become dependent on it, the most expensive and speculative stocks have already been hit exceptionally hard. Furthermore, the quality trade has taken on a more defensive posture. Both of these shifts are very much in line with our 2022 outlook - be wary of high valuations and focus on earnings stability. In other words, favor large cap defensive quality.

Second, with the market and the Fed now fully appreciating that inflation is not going to be transitory, investors must contend with the Ice part of our narrative. How much further will growth decelerate, and how much is due to Omicron versus the ongoing cyclical downturn that began in April? As noted in prior episodes of this podcast, we remain optimistic that this latest wave will prove to be the last notable one. Meanwhile, the peak rate of change in the recovery was way back in April of this year. Since then, we've seen a steady deceleration in growth that has little to do with COVID, in our view. Instead, this is the natural ebb of the business cycle and mid-cycle transition, which is not yet complete. Of course, this latest variant will be a drag on certain parts of the economy and perhaps bring forward the end of the mid-cycle transition more quickly. Finally, this past weekend Senator Manchin effectively put an end to the president's latest fiscal stimulus plan - another negative for growth in the near term.

All of these developments fit nicely with our year ahead outlook for U.S. equities. Therefore, we continue to think most stocks will see valuations come down as central banks remove monetary accommodation and growth slows more than investors expect. Favor defensively oriented stocks over cyclical ones. This includes Healthcare, REITs and Consumer Staples. Meanwhile, consumer discretionary and certain technology stocks look to be the most vulnerable as we experience a payback in demand from this year's overconsumption. While other cyclical areas like energy, materials and industrials could also underperform, ownership of these sectors is not nearly as extreme as the discretionary and tech, nor are they as expensive.

Finally, while major U.S. equity indices remain vulnerable, in our view, many individual stocks have been in a bear market for most of the year. As a reminder, almost 80% of all stocks in the Russell 2000 have seen a 20% drawdown during 2021. For the Nasdaq, it's close to 60%, while 40% of the S&P 500 has corrected by 20% or more. In our view, it makes sense to look for new investments in stocks that have already corrected, rather than the ones that have held up the best. We would recommend a barbell of these kinds of stocks with the more classic large cap defensive names that fit our current macro view.

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