By Michael Wilson, chief US equity strategist at Morgan Stanley
A big component of successful investing is getting the narrative right. Early identification of the correct narrative can lead to great performance, while ignoring the narrative or getting it wrong usually produces the opposite outcome. 2021 may be a perfect example of this playing out in real time. With the S&P 500 up another 20%+ so far this year, many active managers are finding it hard to keep up, as the market leadership has bounced around more than normal.
With that said, the price action in US equity markets this year has followed the script of changing narratives quite nicely. Cyclicals and small caps led the charge earlier in the year as the market contemplated the distribution of vaccines and a reopening of the economy, in line with our early cycle stage recovery narrative. In mid-March we pivoted to a new narrative, labeling it the ‘mid-cycle transition’ – the period when markets contemplate the peak rate of change in growth and policy. This also coincided with the passage of the US$1.9 trillion COVID relief package that put serious cash directly into the hands of consumers. At that time, we downgraded small caps after a historic run and recommended investors upgrade portfolios by buying quality. Since then, the MSCI quality index has outperformed small caps by 21%, a 50% annualized rate. But this is down from 26% just a few weeks ago and leads to the question, Is the mid-cycle transition now priced in?
On the one hand, many of the internal rotations we expected during the mid-cycle transition have played out. In addition to large caps and quality outperforming, early-cycle sectors like autos, transport, semiconductors, home builders/improvement and consumer discretionary have underperformed since mid-March (Exhibit 1). This suggests that we’re now in the later stages of that transition. However, the S&P 500 has avoided its typical 10%+ drawdown as valuations have remained elevated, with large-cap quality in favor. Normally, P/E ratios for the S&P 500 fall by approximately 20% during a mid-cycle transition. So far this year, they have fallen by only 5%. Contrast that with the P/E for the Russell 2000 small-cap index, which has declined by almost 20%.
As noted, small caps have started to outperform the MSCI quality index as well as the S&P 500 and Nasdaq 100, two of the highest-quality large-cap indices in the world. We think this may be the early signal that it’s time for high-quality names to finally take their hit on valuation, completing the mid-cycle transition. Understanding why this might happen could help to put one into the right stocks for the rest of the year. We see two very different possible narratives ahead.
- On the one hand, while the Fed has not yet begun to taper its asset purchases, we think that the start is inevitable later this fall or in the winter. With record GDP and earnings growth, rising inflation and the rates of infection from the Delta variant peaking, the Fed will feel more pressure to remove what is essentially emergency monetary accommodation. We expect a more formal signal from the Fed at the September FOMC meeting, and the markets are likely to anticipate it. That means higher interest rates and lower equity valuations. Our rates strategists expect a move to 1.8% on 10-year Treasury yields by year-end. Assuming a stable equity risk premium at 345bp, P/Es would fall to 19x, or 10% lower. With the quality stocks now expensive relative to the market and arguably more crowded today, it may be their turn to experience the rolling correction that’s been ongoing all year. It also suggests that we get a rotation back towards cyclicals and reopening plays. We favor financials the most in this possible outcome.
- The other reason why we might finally see the S&P 500 experience its mid-cycle transition correction is that growth disappoints. With peak everything, a deceleration is looming, and the chances are increasing that it’s greater than expected, as forecasts have been extrapolated from an unrepeatable 1H consumption boom. In this outcome, we favor defensive quality sectors like healthcare and staples that have less valuation risk in the event rates move higher.
In short, this fall we still expect our mid-cycle transition to end with a 10%+ S&P 500 correction, but a narrative of either fire or ice will determine the leadership from here. As such, our recommendation is a barbell of defensive quality with financials to participate and protect in either outcome.
