From ‘Expansion’ to ‘Downturn’ – Morgan Stanley

One of the latest publication on X-asset strategy comes from Morgan Stanley and the message is pretty grim:

« Our cycle indicators across DM have stalled, pointing to rising risks of a shift from ‘expansion’ to ‘downturn’. The dilemma is that this peak has characteristics of both ‘true’ and ‘false’ turns. We explore our cycle checklist. »

According to MS indicators, « there is a risk that DM markets have entered a ‘downturn’ phase » despite somewhat neutral/slightly positive economic outlook. What are the reasons for concern: a deterioration of OECD leading indicators; lending standards tightening in the US; negative US EPS YoY growth.

Are we at a critical point when considering where the cycle is ? « It’s been six months since the cycle indicators have failed to reach the most recent highs made, and our rules-based indicators are now suggesting that DM markets have potentially peaked and entered the ‘downturn’ phase » write MS’ strategists. »

The difficulty raised by MS is that some indicators point towards a coming downturn while others indicate a ‘false turn’. In terms of asset allocation, valuation, return potential, both assumption have completely different implications… That’s the art of strategist. They can’t explain what’s going on, only long after the market has priced in everything that had to be priced in… and they usually go: « we told you so ».

The report is still interesting because it comprises a list of indicators that investors might want to consider/rely on when they try to interpret the economic cycle. Here’s the list:

  • US jobless claims
  • US unemployment rate
  • Consumer confidence
  • 2/10s yield curve
  • C&I loan growth
  • Consumer loan growth
  • M&A volumes
  • Conference Board US Leading index
  • ISM Manufacturing PMI
  • Industrial production
  • S&P EPS

Some are easy to find and track (look at the amazing Fed of St Louis FRED website). Others are trickier to find unless you can afford expensive databases (but then I assume you can also afford to pay for X-asset research :-).

For equities, if we are at a peak in the current economic cycle, forward returns will turn negative. If, on the contrary, we are in an environment similar to 1984, as MS suggests it might be, « maybe a cycle turn won’t have to translate into more defensive equity positioning. »

Yet one major difference relates to valuation. « While P/E and Shiller P/E were at 10.7x and 9.6x, respectively in 1984 on the eve of the US cycle indicator peak, they are currently at 20.4x and 27.1x. In fact, valuations for US stocks look rich versus averages experienced in downturns and expansions, tempering any overly bullish interpretation of similarities to 1984-85. »

ERP for US equities is therefore very low (2% vs 4-5% in 1984) which is not a very bullish indicator.

In the end, the following table provides some historical perspective based on the phase of the economic cycle.

Source: Morgan Stanley

Source: Morgan Stanley

Conclusion

The strategy that the bank recommends is as follow:

« The current cycle peak, if it indeed turns out to be one, would be an unusual one in many ways – in terms of the trajectory into the peak, the level where it is peaking and in terms of asset class pricing. The conflicting signals we are getting from the cycle turn checklist, as well as the divergent returns expected from our strategists over the next 12 months versus over the long run, lead us to prefer to remain cautiously positioned. We continue to be overweight in credit, equal-weight in equities, underweight in government bonds and overweight in cash. »

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