Authored by Michael Wilson, Morgan Stanley chief equity strategist

Don’t Blame the Fed or Trade – It’s the Fundamentals

Rarely has the adage “Don’t fight the Fed” been more apropos than over the past 18 months. In 2018, the Federal Reserve’s aggressive tightening contributed to a bear market for most stocks, while this year’s equally aggressive dovish pivot has resulted in a new bull market for some. Since our call 18 months ago for a multi-year consolidation in global equities, the average global stock and index is flat to down 10%, while the leading S&P 500 Index is now barely up with a lot of intermittent ups and downs. In short, thanks to the Fed’s policy shift, we’ve seen a consolidation that leaves us at the high end of our expected range.

Last Wednesday, the Fed made good on its dovish pivot by cutting the fed funds rate by 25bp – the first cut in 11 years by the world’s most influential central bank. While it wasn’t 50bp as our team and some others were expecting, the Fed also announced an immediate end to its balance sheet reduction program (affectionately known as QT for quantitative tightening). This combination is unequivocally positive for asset prices. However, to the chagrin of many, the markets reacted negatively, with stocks selling off on Wednesday afternoon and rates plummeting at every tenor, leaving the yield curve still inverted. Investors were quick to blame Chair Powell for failing to communicate a more dovish message, suggesting that they had been misled by prior Fedspeak. But this seems unfair, given that the Fed delivered a more dovish action than had been priced in if you include the end of QT.

Investors should have been more focused on the fundamentals. Going into the Fed meeting last week, my contention was that stocks had already discounted a dovish pivot and investors were potentially ignoring the continued deterioration in fundamentals, as well as other risks including trade. In short, I argued that no matter the outcome, the meeting was likely to provide an excuse for the rally to roll over. After a decent bounce in stocks on Thursday morning, trade resurfaced with President Trump’s tweet that the US would levy new 10% tariffs on the remaining US$300 billion of Chinese imports. This led to a sharp reversal in the afternoon, quashing any lingering hopes that the rally from June was intact. Markets look to have been overly complacent about trade as well. Given the lack of any real progress in talks with China earlier in the week, that risk was still very much alive prior to the president’s tweet.

From here, investors must decide if the Fed can deliver the growth needed to justify current or higher prices. Most investors I speak with still think that this is a mid-cycle correction in the economy and that any Fed cuts are simply an insurance policy. If one believes this, shouldn’t a “mid-cycle adjustment” (in Chair Powell’s words) be enough? Given the very broad and steep decline in many leading indicators and corporate earnings growth, I’ve made the case that we are far from mid-cycle and closer to end of cycle, especially for corporate profits.

On that note, I adamantly disagree with the claim that 2Q earnings have been strong or even good. To the contrary, the results and guidance so far indicate that S&P 500 forward 12-month consensus estimates remain too high and are likely to fall another 5-10%.

Bottom line, the financial markets’ initial negative reaction to the Fed’s first rate cut since 2008 shouldn’t have come as a surprise. Trade escalation is not a new risk; it was simply overlooked.

Therefore, I continue to expect a 10% correction in the S&P 500 this quarter.

So what about the adage that you shouldn’t fight the Fed? History suggests that Fed pauses after a long rate-hiking campaign, like the one we had in January, always lead to a strong market rally – exactly what we’ve seen this year. However, the beginning of a new rate-cutting cycle is typically not good for stocks, as the last two examples (January 2001 and September 2007) clearly show. The lesson is that while a change in Fed policy can affect financial conditions – and hence asset prices – almost immediately, reversing an economic slowdown with easier monetary policy takes time. Stay more defensively oriented in your portfolios until the slowdown is properly priced.