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, April 26th at 11:30AM in New York. So let's get after it.
Over the past month, we've been taking a different path than most strategists. Rather than getting excited about the reopening, we are getting a bit more concerned about execution risk and what's already priced. To prepare for this risk, we've downgraded small caps and consumer discretionary stocks, while recommending a move up on the quality curve.
First, on the execution front, we are hearing more anecdotal evidence that supply remains a problem for many companies, just as demand is picking up. These issues have been more concentrated in certain materials and components until recently, where it's now becoming more apparent that we have labor shortages as well. We first began highlighting these concerns last month, and now we’re even more convinced that these concerns are warranted. On valuation, the risk is elevated too. But, with liquidity still flush and headline indices making new highs every day, few seem worried. From our vantage point, the equity risk premium is very much underpricing the risks we have discussed: peak rate of change in fundamentals as well as policy and liquidity, cost and margin pressures, equity supply, and extreme investor leverage.
In addition to the cost and execution issues we’ve seen with the reopening, there is also a question of demand, at least relative to the lofty expectations. As we have been stating for months, perhaps the most unique characteristic of this recession and recovery is the speed in which it has happened. Some have referred to it as a natural disaster rather than a recession at all. While we don't agree with that characterization, there are similarities in how markets have treated it. In our view, the economic cycle is determined by many things, but no variable is as important as determining where we are in the cycle as the unemployment rate. On that score, we have already recouped 80% of the spike in unemployment, and we’re now back to 6%.
Looking at historical recessions and recoveries, we’ve never seen unemployment rebound like this before the recession was over. That alone is a signal things are different this time and begs the question— what are the consequences of a tight labor force before the recovery begins for many activities? Along those same lines, retail sales have held up remarkably well too during this recession. Never before have we seen real retail sales grow on a year-over-year basis during a recession. However, this time not only are retail sales growing, but they’re growing at rates we have never witnessed before. In fact, on a cumulative basis, retail sales are above where they would have been had we just stayed on the same uptrend pre-COVID. In short, COVID has led to greater retail sales than we would have seen without it. Of course, this begs another question: is there really pent-up demand? Or should we instead expect a payback in demand as people get back to their normal lives?
For the pure work-from-home beneficiaries, we see the latter conclusion as pretty obvious – in other words there will be a payback on demand, as the pull-forward will not be repeated. While there are some obvious candidates for payback that the market has already recognized, there may be more of these payback stories than perhaps many are expecting. Just because people have the savings doesn't mean they’re going to go out and buy more "stuff" than they already have. Bottom line, we think this is another underappreciated risk we have not previously discussed. On the upside will be the services and things people have not been able to consume during the pandemic—like travel and leisure activities.
However, the cost to deliver these services is going up, if not becoming altogether impossible. While materials prices and supply chain issues have been well documented for months, labor shortages are now also being widely reported, with the latest NFIB small business survey suggesting it has never been harder to fill job openings. In the near term, we think this means a profit squeeze, which is also starting to show up in the survey. Ultimately, these costs may be able to be passed on but that leads to inflation that is much more persistent than the Fed and many investors expect.
The bottom line, dreaming about a reopening is likely much easier than doing it. Given that stocks are discounting machines, that means it’s often better to travel than arrive from an investment perspective. As a result, we think it’s time to reduce equity risk until either these risks are better reflected in earnings expectations, price, or both.
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