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Morgan Stanley’s Shalett: Recession, 10% Dip Likely – Barron's

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Kate Copeland

THE FEDERAL RESERVE IS SIGNALING rate cuts amid disappointing global economic growth. But Fed action may be too little, too late to avert a U.S. recession, according to Lisa Shalett, chief investment officer, Morgan Stanley Wealth Management: “They’re trying to fight the end of the cycle, and that’s very hard to do.”

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Sitting down with Barron’s Advisor, Shalett — who is an investment thought leader for Morgan’s nearly 16,000 financial advisors — explains why a recession in the next year is a strong possibility, and why stocks may soon drop by at least 10%. She weighs in on the durability of the so-called Trump put. And she advises investors to add underperforming sectors: “What we’re saying is, buy into the current weakness.”

Q: Stocks and bonds have been sending conflicting signals over the past several weeks about the direction of the economy. What’s going on?

A: The bond market clearly has been looking at the deterioration in inflation expectations and really in the fundamental macroeconomic data, and coming to the conclusion that the Fed is probably behind the curve, as they very often are in economic downturns, and will need to cut aggressively to “catch up.”

The stock market seems to be looking through that and believing that Fed action at this point will actually catalyze a soft landing. And on the other side of the soft landing, which probably would happen in the next couple of quarters, we’ll have a resumption of profit growth, and that we’re off to extending the macroeconomic cycle quite nicely.

Q: Do you think the stock or bond market has it right?

A: In this particular case, we think the bond market is more right than the stock market. The stock market seems to be betting on only good news, and not the potential for bad news. And the bad news that we see isn’t even just so much an economic recession – which we think would be reasonably modest – but that earnings are genuinely at risk. And there seems to be an under-appreciation of the extent to which negative operating leverage could factor into earnings misses.

Q: So if bond investors are right, stocks will presumably decline — but by how much?

A: [They’ll] decline in proportion to their starting point. Our sense is that fair value of this market is somewhere around 2,750. So if we make a move from current levels, you’re talking about a 10% correction; if the market goes to 3,100 or 3,300 before that correction, it could be more material.

Q: What would prompt the stock market to sell off?

A: I think there are a series of things that would get the stock market’s attention. Number one, significant earnings misses this quarter, with negative earnings guidance, and we put a reasonably decent possibility on that.

The second thing is a little bit more truth serum around where we really are with trade negotiations and the likelihood that we’re going to get a deal. We continue to think that the odds of getting an actual deal that removes tariffs is low. And then I think any kind of negative surprises about Fed policy. We’re in the camp that says the Fed is in a very tough spot, because whatever they do, they’re going to be criticized.

Q: You wrote recently that the composition of the stock rally could be a warning sign. What did you mean?

A: If the stock market really believed its own headlines — that the economy was going to soft land and we were going to have a reflationary bounce — then you would expect cyclical stocks to be leading. Things with high beta, small caps, which benefit from a rebound in the U.S. domestic economy, you would expect them to be doing better. And in fact, small caps, financials, energy stocks, commodities, these are all lagging. And that’s not validating of this soft-landing/reflationary bounce thesis that seems to be supporting the stock market right now.

Q: Talk about some of the worrisome signals you’re seeing in the economy.

A: Probably the single most important and provocative one at the minute is the rate at which global manufacturing new orders have plummeted. New manufacturing orders tend to lead global, and S&P 500 for the matter, profits by about 12 months.

We’ve seen a much bigger and swifter deterioration in new orders than we saw in 2015-2016. And in 2015-2016, stock markets got nervous. And it doesn’t seem like stock or credit markets are getting nervous this time. They fully believe that the Fed is going to bail them out.

Q: You mentioned that you expect only a mild recession. Why?

A: One of the issues is that we haven’t had a ton of excesses this cycle. So any recession is likely to be shallow. It’s likely to look, feel and smell a lot more like ‘90-‘91 than the [most recent] two crises-related excesses that we’ve had. When we talk about the likelihood of recession, one of our favorite models has been the model that is published by the New York Fed. The New York Fed model just updated their probability of recessions this morning; it’s now at 32.88. Every time that reading has pierced 30%, the U.S. economy has had a recession. So we’re now saying that in the next 12 months, there’s a one-in-three chance of having an economic recession with a pretty high degree of certainty that it’ll happen at some point.

Q: How do June’s strong jobs numbers affect this narrative?

A: What the narrative suggests is that the Fed’s going to have a hard time. They’re trying to fight the end of the cycle, and that’s very hard to do. At the end of the cycle, you tend to have lagging variables peak, and employment is a lagging variable. What we’re seeing is hiring continuing to be robust, but the forward outlook deteriorating. What that does is, in a data-dependent Fed, on the one hand it prevents them from being overly aggressive — it took the 50 basis point cut off the table — when in fact the forward look is that they probably do need to cut. They’ll just cut slowly. And that pretty much suggests that you’re going to have this mismatch.

And again, we’re in the camp that says that’s OK, because you always have a mismatch. By the Fed saying, “We’re going to do this insurance cut, we’re going to save the cycle, we’re going to extend the business cycle — that’s never been the Fed’s mandate.

One of the things that is troubling to us is that the Fed is skating on this very thin line where they are potentially victim to having their mandate politicized. Extending the cycle is something that politicians talk about, not something central bankers talk about.

Q: Powell and the Fed are definitely facing direct political pressure right now.

A: Central bankers have historically talked about two things: price stability and full employment. We’ve got both. Even though people want to kind of fight the definitions around inflation expectations, the reality is that CPI has been running at above or close to 2% for most of the cycle; it’s been very stable.

So we have those two things. Bernanke and Yellen introduced the concept of financial stability as the Fed’s third rail. But Powell seems to be marching down this path of “Our job is to insure the economic cycle.” And that’s never been the Fed’s mandate, making sure that we have high stock markets. I think it’s dangerous if we go down that path.

Q: That brings us to the so-called Trump put. Would you explain what that is?

A: Increasingly, we have talked to clients and investors and participants in markets, and they are talking about the Trump put. What they mean by that is that, because the current president has publicly declared that one of his primary scorecards is the stock market — and he watches it like a hawk — that he will navigate policy and navigate his announcements regarding trade progress or not trade progress, et cetera, completely proportional to gains and losses in the stock market.

And so if investors believe that he has that power, then at a certain point if enough people believe something it becomes true. Meaning he does have that power. And so there is this emergence of the Trump put, which is that he will, through his rhetoric and announcements about policies, attempt to prevent a downturn in the stock market.

Q: Is that something that investors are wise to bank on?

A: We’re not here to say it won’t work; it’s worked – but we’re just saying whenever markets get this disconnected from the fundamentals, they’re vulnerable.

It’s great to say, hey, I don’t necessarily have valuation support in the market, I don’t necessarily have fundamental economic support in this market, but I’m buying on sentiment. That works very well in short periods of time, but it’s harder to maintain that disconnect over the intermediate term. And so what I always say to people is, that’s fine until the day it’s not fine.

History teaches us that what catalyzes the “not fine” is typically very hard to pinpoint. It can be a headline, it can be a company making a disappointing announcement, it can be a geopolitical event, it can be a natural disaster. It can be a million different things that starts the fire, and then once the fire gets started, you have an unwind of sentiment.

And so we caution our clients against chasing sentiment-oriented markets. And we feel that we kind of crossed the Rubicon when we crossed 2,900 on the S&P into the sentiment, where people are chasing momentum.

And again, the technicals of the market right now remain OK. And so the technicians and the momentum are a near-term support. But they’re very vulnerable to news.

Q: Given your outlook, what are some opportunities that investors and financial advisors should be looking at?

A: The things we want investors to be looking at, particularly if they’re going to rebalance their portfolios away from winners into losers, or if they’re going to be redeploying cash into this market, are those companies that have valuation support.

That means areas like financials, small caps, industrials, healthcare, commodities, materials — the things that have underperformed. What we’re saying is, buy into the current weakness that we’re seeing. The quality, the growth, the momentum-oriented parts of the market we believe are the ones that are crowded and overbought. Where defense is overpriced, where growth stocks are rich, that’s where we would be taking profits, because we think that’s where the disappointments are going to come.

Whenever people pile into one corner believing something – that these companies are stable or these companies are high-quality or these companies are immune to a slowdown, or won’t be affected by trade with China — where the negative surprises come is where those companies actually are. It’s the companies where they’ve already discounted the vulnerability where we think there’s more of a margin of safety, and we’d rather be playing the role of a value investor here.

Q: Which indicators will you be watching most closely in coming weeks?

A: I think in the very short term, we’ve got to look at what inflation is going to do. I think that’s going to be the next major data point for the Fed. And obviously we need to continue to watch the data around trade.

I think the U.S. dollar is going to be a key variable. One of the things that a lot of people don’t fully appreciate is that the strength of the U.S. dollar has been a phenomenon for most of the past 11 years. And a strong dollar is actually very deflationary for the global economy. That’s because most commodities are priced in dollars. When the dollar is strong, it depresses the price of commodities and that strong dollar if it were to reverse could be a material tailwind to the rest of the world’s economies recovering.

Q: Beyond the next year or so, what’s your longer-term market outlook?

A: Here’s the key thing. We believe that we’re going to have a correction in markets. But on the other side, we still believe that there’s a secular bull market in the United States and in equities. And so it’s just a question of knowing when to chase and knowing when to take a pause. And we’re just in one of those pause phases. This too shall pass, you’re not missing out on anything, you’re going to get a chance to own the S&P at 3,000 again. But at the same time, there’s a lot of good things that will come on the other side of the recession because you have a slowdown and you clean up and you rationalize and that allows for recovery.

Q: Thanks, Lisa.