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The S&P 500 finished its worst first six months of a calendar year since 1970, falling 20%. The U.S. bond market fell 10.4% and is on pace for its worst year in history. It sounds extreme because it is, and it’s pretty peculiar. Usually when stocks are having a bad year, bond prices rise and cushion the blow. That’s been the pattern in the past eight corrections or bear markets for stocks. Hence the once-upon-a-time wisdom of the 60/40 portfolio. But so far, in 2022, both stocks and bonds have been tumbling down the hill together, and the 60/40 portfolio is having its worst year on record. That’s tough for older investors who’ve been playing by the old rules of shifting their portfolios more towards bonds for capital preservation. It’s been no easier and actually a little harder for younger investors who are tilted so aggressively toward stocks, especially growth stocks.

But before we get all bullish again, let’s get some perspective on bear markets and how fearsome they can be. The S&P 500 is down about 20% so far this year. That’s the total return, including dividends. The worst calendar years for the index, however, were much worse. In 1931, the market fell 43.8%. That was the Great Depression. The great financial crisis in 2008, the market fell 37%. In 1937, it fell 35.3%. And in 1974, it fell 26%. Do any of those eras seem similar to what we’re experiencing today? Rampant inflation? Sounds like the 1970s, but U.S. consumers were in far worse shape back then. Rising interest rates? Those were more of an early ’80s thing used by the Fed to bring down inflation. Geopolitical uncertainty? Every era had that, including the 1930s and the 1970s, but that wasn’t what sent the stock market into a tailspin. Taking a long-term perspective, though, on the stock market eases the pain a little bit. The S&P 500 has delivered a better than 10% average annual return going back five, ten, and 15 years. This era, though, still is kind of unique, and it may actually be more similar to the 1940s in the United States.

Meet Mike Wilson

MarketWatch


Mike Wilson is Morgan Stanley’s chief U.S. equity strategist and chief investment officer. Mr. Wilson has been with Morgan Stanley’s since 1989, originally starting his career with the firm as an investment banker. Between 1995 and 2012, Mike held various positions within the firm’s Institutional Equity Division, including the head of content distribution for North American equities. By 2012, he had been appointed CIO of Wealth Management.

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We know the narrative well. The worst first half of the year for the U.S. stock market since 1970. The drumbeat around a recession getting louder by the day. Geopolitical uncertainty in all corners of the globe. A central bank struggling to hold the wheel as it tries to engineer a soft landing. This is the state of play as we dive into the second half of the year, and it’s time to get our playbooks ready. Mike Wilson is the chief U.S. equity strategist and chief investment officer for Morgan Stanley and chair of its Global Investment Committee. Mike and his team have been among the more prescient market watchers and forecasters among institutional investors calling this bear market way back at the beginning of the year. And their forecasts call for more bear encounters this summer. We’re going to need a wildlife expert to keep us safe out there this summer. We’re pleased to welcome Mike Wilson on The Express this week. Thanks so much for being here. 

Mike:

“Thanks for having me. Looking forward to it.”

Caleb:

“You and your team have laid out several scenarios for the back-half of the year and how that’s going to play out. Let’s start with your base case and what seems most likely given what we know now.”

Mike:

“I mean, the base case is quickly turning into the bear case, unfortunately, because as you mentioned, the risk of recession is increasing, but we’re still holding out hope that we can avoid a recession. It’s probably a 60% chance but that’s growing…. the recession chance is growing up from 40% plus. So, in that base case, we assume a soft landing that the Fed can orchestrate an extension of the business cycle, if you want to call it that. But the problem is that we still see earnings risk even in that outcome because there’s still payback and demand, there was over-earning by good portions of the economy.”

“So, even though the economy may be okay to hold together, the earnings power of the market may come down because you have a shift from goods to services, which is much less accretive to, say, S&P 500 earnings. You have margin pressure now. So, even though growth is good at the top line, companies are having a hard time bringing it to the bottom line because the costs are now increasing faster than the end price point. So, in that scenario, we think there’s about 5% to 7% downside to forward earnings estimates, which are currently about to $240 on the S&P 500… And then, unfortunately, the multiple really isn’t going to get much relief because in the soft-landing scenario, rates don’t come down.”

“So, rates will stay elevated, probably closer to 3%, maybe even higher, as the economy continues to grow and the Fed continues to raise rates. And so, the multiple… you really can’t get much more than 14 and 15 times earnings, and that’s $3,400 sometime this fall. Now, the good news is from there you’ll grow again and then earnings will drive the market higher. In the bear case, the recessionary outcome, which is growing in chance, the earnings risk is obviously greater. It’s probably closer to 20%. And now you’re talking about $195, $200 in earnings power… And the multiple still isn’t going to be much higher because when you go into recession, the equity risk premium usually blows out because when you go into recession, you don’t know if you’re gonna come out.”

“So, that’s the trick. And I would say the downside target in that recession scenario is about $3,000 before you can recover. Now, this may sound crazy to you, but the bull case is that the recession comes sooner. Do you actually just have it, get it over with, and then the market will be able to look forward? You don’t do any structural damage, you can get the labor market back where it needs to be, businesses will quickly adjust, and the market will like that, and then you can actually grow forward from there. So, it’s a very interesting set up. It’s going to happen fast. This whole cycle’s been very quick. And I suspect we’re going to know the answer to a lot of this probably by October.”

Caleb:

“The bull case sounds great. It would be great to get this over with quickly. At the same time, you know this well, things have changed. We have an environment where the Fed is raising rates, we have persistently high inflation, and we’re just not going to get the kind of growth that we’ve gotten in some of the big, especially mega tech, firms that have been the drivers of growth over the last decade or so. So, things are never going back to the way they were. But what kind of a growth scenario could that be at best?”

Mike:

“It’ll be a more balanced growth, though. Think about it this way: I mean, yeah, we’ve had these great tech companies, great margins generating a lot of profit growth, but it’s been very narrow. It’s kind of like the 1% economy. We talk about the 1% economy for individuals. It’s been the 1% economy for corporates too. So, what I would hope is as you come through this next downturn, whatever it is, that you’re going to see actually a more synchronous recovery globally. Think about post-COVID-19. We haven’t really had a recovery outside the U.S. yet to speak of at all. We haven’t had what I would call real investment in real things for a long time. And this cycle clearly is embodying the need that’s showing us that we need to invest in real things that can drive higher productivity. So, I’m actually quite optimistic that we can get through this adjustment period, and that we’re going to have higher nominal GDP growth globally. And obviously multinational companies… which are tech and non-tech, can actually participate in that. And you can actually generates some pretty good earnings growth.”

Caleb:

“Well, I’ve heard you talk about the need to be looking for companies now that have strong cash flow, dependable revenue, and the ability to bring that cash flow to the bottom line. Looking at the basic fundamentals here; block and tackling good, solid companies. Is that right?”

Mike:

“That’s exactly right. What the market’s paying for now is what we call operational efficiency. And it’s a nice way of saying, ‘They’re paying up for companies who can deliver on cash flow and earnings.’ So, the days of growth at any price or profitless growth, that’s over. We’re not going back to that world. Now, that doesn’t mean that every growth company or tech company is doomed. It does mean, however, growth companies or tech companies that don’t generate profits or have a path to profitability in a reasonable time frame… I think those types of investments are going to be challenged and obviously have been challenged. And I would tell the listeners here that if you own some of that stuff still, I would probably be looking to sell them at rallies because this is the kind of thing that could be an underperformer for ten years, or it may even go away. So, that’s the biggest change I see in the landscape. It’s going to be more balanced. Growth companies can do just fine, but you better make sure they have profitability or at least a path to profitability.

Caleb:

“Well, you and your team counsel institutional investors about how to allocate capital. They have to do this. This is what they do for a living to make money. But for individual investors, like a lot of our listeners who are just trying to protect and grow their wealth, what do you advise as we’re facing these challenging next few months and potentially next few years? This is a different cycle altogether than a lot of folks have ever experienced.”

Mike:

“Absolutely. So, we had this narrative at the beginning of the year; we called it ‘Fire and Ice.’ And the reason we’ve had such a tough time this year is because you have the Fed and central banks tightening policy into a slowdown. It’s actually unprecedented in some ways. It’s very rare to see monetary policy being tightened into an economy that’s slowing or profit cycle that’s slowing. But that’s where we found ourselves because inflation has gotten out of control. So, they don’t really have a choice.”

“So, the first half of the year was bad for everything. All financial assets suffered because there was this hammer coming down from the Fed and other central banks. And tightening financial conditions is bad for stocks; it’s bad for bonds; it’s bad for even commodities to some degree, which is not doing well recently; real estate, you name it. The second half of the year is going to be all about growth. The Fed has done their job now. They’ve already told you about what they’re going to do. That’s why mortgages are so high now, why housing is slowing. So, the second half of the year is going to be about growth slowing.”

“Now, in that environment, bonds actually do quite well. And I sense, even at our own network, retail investors and asset owners in general have started to really shun bonds because inflation was moving up, and that was the right decision. The problem is it went too far. For all the complaining or talk about how bad stocks have been in the first half of this year, bonds have actually been worse relative to their history. I saw a stat today, it was the worst year for the first half of the year since 1865. So, that’s basically the worst ever. So, I don’t hear many people saying, ‘No, it’s time to buy bonds.’ But that’s what you should do. If you have cash or you have maybe a little bit too much equity risk, buying long-duration Treasurys here is actually a really good way to hedge your portfolio as we go into this growth slowdown and potential recession. And that’s a trade because you want to eventually then buy stocks again when they get cheap enough, but in the next three or four to six months, that could be a really good idea for people.”

Caleb:

“You have to know when to make that rotation out again, which is why you got to listen to the signals, which is what you and your team do. So I love the Fire and Ice metaphor. I don’t know if you’re referring to Pat Benatar’s hit song or Robert Frost’s poem, but both apply in this case. So, I was going to ask, though, if we need to reset our portfolios with reasonable and practical expectations for the next three to five years, what are some basic rules we need to adhere to and what are some basic things we just need to accept as investors? The days of 8% to 10% average returns on the S&P 500, are those over for the near-term?”

Mike:

“I think there’s a couple of things. Number one, we are kind of leaving Kansas, Toto, in one way, which is that your inflation is here to stay. Now, that doesn’t mean 10% inflation is here to stay. What it means is that we’re not going to be at 1% to 2% and in an environment where interest rates are continually coming down and the Fed is in a position to always bail us out. So, you have to act more like an adult and these valuations are not going to get out of control. So, valuations are never going to get to where they were again if there’s this underlying inflationary pressure that forces the Fed to be quick handed when inflation gets a little bit out of hand like it is now, then they’re going to continue to do that. It also means we’re likely to have more frequent recessions.”

“Now, when you say the word ‘recession,’ it conjures up all these terrible feelings because in the last 30 years, every recession has ended with the financial crisis. But that’s because you had ten-year cycles where you end up having too much malinvestment and it blows up in the end. If you have recessions every three or four years, it can actually be quite helpful. It cleanses. It’s like cleaning your room: If you do it every week, it’s not so bad. If you wait six months, it’s going to be a problem. So, what I would encourage clients to do is not get too beholden to this long-term buy and hold. You’re going to be a little bit more tactical around these ideas of saying, ‘Okay, when asset prices get cheap in stocks I’m going to really get aggressive,’ but then watch it closely. And when they get ridiculously expensive like they did last year, we all knew it was ridiculously expensive and nobody wanted to sell because I was like, ‘Well, I don’t want to miss anything.’ You have to be more disciplined. Now, maybe that requires you to have an advisor, read more about this, and follow it more closely. But if you do that, you can absolutely generate 8% to 10% returns in the portfolio. If you don’t do that, then yes, it’s probably going to be more like 5% to 6%, which isn’t the end of the world. But if you want to generate outsized returns, you’re gonna have to be a bit more tactical.”

Caleb:

“And there’s always a good time to have a financial advisor, good time to also understand the fundamentals here and see what’s going on in the market. Because you’re right, we’ve got to act like grownups. The punchbowl has been taken away, whatever metaphor you want to use. We’re out of Kansas, absolutely. A few months ago, everyone was talking about a supercycle for commodities. Obviously, crude oil prices have been spiking. They’re coming down. They’ve come down quite a bit. But Russia’s invasion of Ukraine had something to do with that. But we also saw spikes across the commodity basket there. A lot of that has come off. Is that demand destruction because of inflation or the fear that we’re heading into a recession? And that’s why we’ve seen some leveling of prices, especially in copper and a lot of those important metals.”

Mike:

“There’s no doubt that the base metals are directly tied to what we think is a slowdown in the global economy. We see it in the data, whether it’s export orders, consumption. And there is demand destruction going on. There’s also payback and demand in a lot of different things. We overconsumed quite a bit, particularly in the United States, in that utilized… there was a double ordering that was going out of hoarding of commodities. And now commodities are classic price destructive asset classes, meaning the cure for higher commodity prices is higher commodity prices.”

Caleb:

“Yep, higher prices.”

Mike:

“And that’s what we got. And they’re very forward thinking, and so I do think that the signal that we’re getting for the base metals is pretty obvious. Oil is trickier because you would think, ‘Well, I didn’t know there was all this oil.’ What that tells me is that the oil in Russia is definitely getting into the market, 100%. We’re not as short on oil perhaps as many people think. I think we’re short on refining capacity in many ways, but I’m not sure we’re short on crude as much as people think, assuming that the oil that’s being pumped in Russia is actually getting into the global economy and being consumed, which I think it is, which is also being dictated by the current account surplus that we’re seeing in Russia. And the ruble is going through the roof. So, clearly they’re selling it to somebody.”

Caleb:

“Give us your hot take. What’s the one thing people aren’t really talking about right now as it relates to the capital markets? That could be a big factor through the rest of the balance of 2022 or even into 2023. What’s the thing that you think needs more attention than it’s getting?”

Mike:

“Well, there is one thing, but I do want to give the listeners a little preview of something to think about because we tend to think a little further in the future than maybe other strategists who are willing to go out there and put our neck on the line. And we won’t be right, necessarily, but we think this makes a lot of sense, which is: I hear a lot out there that this is the 1970s, and that we’re going to have a stagflation environment if we go into recession. And we think it’s nothing further from the truth. We think it’s really the 1940s and the main differentiating feature to think about, which everybody understands, is it the ’70s was really a cost-push inflation. We had a shortage of supply in a lot of different things. Labor, commodities, various other components. And that’s why inflation was so sticky.”

“What we have today is demand pull. We had too much demand. We overstimulated demand and then we had logistical constraints as opposed to supply constraints. And those logistical constraints are now being fixed. So, I think you need to think really hard, and when we get to this fall, if we’re moving into recession and markets really sell off, I can guarantee you the… birds are going to be out in full glory talking about stagflation and how we’re really screwed. And what I would like people to just keep an open mind to is, ‘No, we’re in a boom bust environment. And I can assure you that what follows a bust is a boom. Just like what follows a boom is a bust. So, just keep your mind open to that idea, and in the darkest hour this fall we’ll be pretty vocal about it. But I think you need to be open minded to the idea that inflation is a backward-looking statistic. And if you look forward, if you actually have a recession, inflation is going to be quite low next year and actually deflationary in a lot of areas where we overconsume and now there’s excess inventory.”

Caleb:

“Well, great point. And I love the analogy to the to the ’40s but also, to the point you made earlier, a lot of these cycles seem to be happening a lot faster than they used to. These are compressed time periods. Obviously, the quick recession in the spring of 2020, the quick recovery from that, you know, some of the fastest on record. Are we just going to be headed for faster and faster cycles going forward and have to deal with that as investors?”

Mike:

“I mean, that was the title of our report a year and a half ago, which is ‘Hotter but Shorter Cycles.’ And it lines up exactly with the ’40s again. So, if I told you from 1945 to 1961, we had five recessions, it might surprise you because during that period it was the glory days for the United States. And we actually had a very good stock market, terrible bond market, but a very good stock market. In other words, the point being is that boom bust don’t have to be bad investment environments and they don’t have to necessarily be bad for average people if they know they can job hop, they can get wage increases, and they can manage your lives. But you have to have a little bit of a foresight and understand what’s going on.”

Caleb:

“Great point. All right, we’re going to go out on this. We like to ask our our guests, especially those who are black belt investors, for their favorite investing term. We’re a site, as you know, built on our investing terms. What’s the one that just sings to your heart, the one that just makes you happy whenever you hear it or whenever you get to use it?”

Mike:

“The thing that I think people overlook all the time because people watch media, and it’s always about the scoreboards, like, ‘Well, it was up, so I was right.’ That’s not a good way to invest. It’s always about risk/reward. That’s like saying, ‘Well, I went out Friday night, I took all these chances, and I got home safely.’ Yeah, well you got lucky. You got to be really disciplined, and understanding risk/reward will keep you out of trouble. And most importantly, you will be adding risk at the right time.”

Caleb:

“Great one. You’re the first one to bring up risk/reward but probably one of the most important for investors out there of any age. Mike Wilson, the chief U.S. equity strategist and chief investment officer for Morgan Stanley, thanks so much for joining The Express. We really appreciate it.”

Mike:

“Thanks for having me. It was great to be here.”

Term of the Week: Terminal Rate

It’s terminology time. Time for us to smarten up with the investing term we need to know this week. We like Mike Wilson’s favorite term risk and reward, but Mike brought up another term that got me searching: the Fed’s terminal rate. That term doesn’t get used a lot these days, but it’s important to understand the central bank’s plan to raise interest rates throughout the year. According to my favorite website, the terminal rate is what economists call the natural or neutral interest rate. It’s the rate that is consistent with full employment and capacity utilization and stable prices. Those are the Federal Reserve’s mandates. Asset managers and borrowers have to take the expected central bank’s terminal rates into account in planning, investment, and funding decisions.

In the United States, Fed fund futures are pricing in over 300 basis points of rate hikes, implying a terminal rate of around 3.9% by mid 2023. That’s up from around 3% at the start of June. For the European Central Bank, money markets now price in around 290 basis points of hikes to put rates at around 2.4% by July of 2023. This compares with a rise of 1.5% by early 2024, priced at the start of June. Those are big changes, and they are a stark contrast with May, when traders had cut estimates on where terminal rates would peak. Investors thought inflation had peaked, we were wrong. And investment banks have been ramping up their forecasts for terminal rates. Here in the United States, Deutsche Bank economists recently raised their Fed terminal rate forecasts to 4.1 to 5% by mid-2023, while Morgan Stanley said that if the current inflation backdrop starts to look like it did in the early 1980s, markets could price in a terminal rate of between 4.5% and 5%. I’m glad Mike brought that up. We’re going to be sending him a pair of our world-class famous socks for joining the show this week.

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