Having been one of the most bearish voices on Wall Street for a good part of 2018, with downgrades of small caps and tech stocks earlier this summer and one month ago going so far as to call the peak of both Treasurys (in September) and Stocks (this December)…
… in his latest Sunday Start note, Morgan Stanley’s chief US equity strategist Michael Wilson, takes what may end up being yet another premature victory lap following the latest equity selloff inspired initially by surging rates and the continued chaos over the Italian budget process and – overnight – the Chinese market crash, and writes that “the break higher in interest rates last week appears to be the tipping point, enabling the rolling bear market to complete its unfinished business in these last bastions of safety.”
Wilson also reminds us that based on the bank’s Equity Risk Premium framework, the S&P 500, as a whole, had become overvalued for the first time since January, and that “this overvaluation was apparent as yields on the 10-year broke through the 3% barrier. Small caps had already been underperforming for several months, but as rates moved above 3%, their underperformance accelerated. With last week’s surge toward 3.20%, weakness finally came to the high-flying growth stocks where valuation is the most stretched.”
In short: for Wilson, it’s all downhill from here, even though the stock peak appears to have come some 2 months earlier than he had predicted earlier.
We present his full note is below:
The Tipping Point
September bucked the normal seasonal pattern, proving to be a fairly calm month for financial markets. Global equities even started to broaden out a bit with international stocks doing better, led by Japan. Credit markets also displayed resilience with one of their better months this year, despite the fact that the rates market was suffering one of its worst. The presumption was that global growth was improving and could be more sustainable than markets had feared.
As we entered October, the move in rates continued, with the 10-year Treasury yield making new highs last week in dramatic fashion. We’ve often found that it’s not the magnitude of the rate move that matters most for financial markets, but its speed. Last week’s surge checks both boxes—it was big and fast!
Perhaps Japan’s newfound leadership in September was an early warning that this rate move was coming. After all, Japanese equities would stand to be the biggest beneficiary of rising global inflation and interest rates, accompanied by a stronger US dollar. Emerging Markets, on the other hand, don’t fare as well under this scenario and have been a laggard in September and so far in October.
Since July, we have been recommending that investors fade the areas of relative strength in global equity markets—US small caps, Tech, and Consumer Discretionary shares—in favor of some of the laggards like Japan, Europe, Energy, Industrials, and Financials. In short, we’ve been recommending value over growth on a global basis. Over the past 10 years, growth stocks have absolutely trounced value stocks worldwide. In the era of below-trend GDP growth and negative real interest rates, it was logical for investors to favor a barbell of steady income and growth stocks. Therefore, early in the recovery from the financial crisis, this led to extraordinary performance in bonds and income, producing stocks known as the “dividend aristocrats.” Growth stocks also enjoyed most-favored-nation status.
However, as interest rates began to rise from their secular lows in summer 2016, bonds and the dividend aristocrats started losing their luster, while growth stocks continued to attract capital and re-rate even higher. I think this disconnect made sense when rates were still very low. Bonds and bond proxies are sensitive to moves higher in interest rates from any level, while growth stocks remain immune until rates cross a certain threshold. Was that level breached last week? We think the answer is yes, because growth stocks now are less attractive while many discarded value stocks, like financials, become more appealing. It’s notable that last Thursday the MSCI World Value Index had its greatest one-day outperformance relative to MSCI World Growth since May 2009.
In our US Equity Strategy research, we highlighted in September that the S&P 500, as a whole, had become overvalued
for the first time since January, based on our Equity Risk Premium framework. This overvaluation was apparent as yields
on the 10-year broke through the 3% barrier (see Exhibit). Small caps had already been underperforming for several
months, but as rates moved above 3%, their underperformance accelerated. With last week’s surge toward 3.20%,
weakness finally came to the high-flying growth stocks where valuation is the most stretched.
Given their lack of dividends and high valuations, high-flying growth stocks are arguably the longest-duration assets in
the world. Therefore, it’s perfectly reasonable that they would eventually succumb to rising rates. We just didn’t know
at what level it would happen. Much as in January, when a sudden move higher in the 10-year yield led to a rapid and
broad 12% correction in US equity valuations, we see a similar risk for the smaller cadre of stocks and assets that have
maintained their valuations since the January highs or moved higher.
This was precisely our call back in July when we downgraded US small caps and Tech stocks. At the time, we thought the valuation gap would close as the sustainability of growth was called into question. However, the break higher in interest rates last week appears to be the tipping point, enabling the rolling bear market to complete its unfinished business in these last bastions of safety.
With the recent 10-year Treasury move, the S&P is now overvalued for the first time since January