Stockmarket valuation support still lacking: Morgan Stanley

Ahead of US CPI and retail sales data this week, markets want signs of better economic growth or more monetary policy support to get excited again. Neither is likely in the near term.

With valuations remaining high, defensive quality stocks are still the best option according to Morgan Stanley’s chief investment officer Michael Wilson. Picture: Getty Images

Volatility in markets has cooled somewhat as worst case scenarios were ruled out last week.

But with valuations remaining high, defensive quality stocks are still the best option according to Morgan Stanley’s chief investment officer Michael Wilson.

Ahead of US inflation and retail sales data this week, he says markets want evidence of better economic growth or more monetary policy support to get excited again but are unlikely to get either in the near term, leaving the S&P 500 stuck in a 5000-5400 range.

With the US benchmark approaching the top of that range after bouncing over 4 per cent in five days, as the VIX volatility index fell back to 20 per cent after briefly spiking to 85 per cent amid US recession fears and yen carry trade unwind last Monday, Mr Wilson says it makes sense to “skew defensively” in portfolio positioning as rates are set to fall.

His view remains that economic growth is now the primary concern for equity investors, rather than inflation and rates. Stockmarkets need “good” economic news to rally further.

“In that context, bond markets believe the Fed is behind the curve and this risk is not priced into current equity multiples, in our view,” Mr Wilson said. “While data will determine the ultimate direction of policy and markets, we don’t think it will be definitive in the short term, leaving markets to trade in a range that assumes a soft landing is still the base case.”

Of course, support can also come from cheap valuations, but that’s not yet the case.

Mr Wilson said the S&P 500 is still trading on about 20 times forward 12-month earnings, whereas his fair value multiple – assuming a soft landing in the economy – is closer to 19 times, “which means things aren’t cheap relative to fair value until we reach 17-18 times”.

“This is especially true given earnings revisions breadth is in negative territory and points to softness in forward EPS growth,” Mr Wilson said. “Keep in mind that we don’t actually need a hard landing for valuations to normalise as evidenced by the valuation resets of the last couple of years.

“As we have been discussing for months, the market’s main concern is now growth rather than inflation or higher rates like in 2022 and 2023.”

His analysis of US earnings transcripts shows companies were increasingly focused on preserving their profit margins as “input cost” mentions ticked higher, a trend that does not appear to be offset by pricing increases.

In line with this focus on expense discipline, “efficiency” mentions rose and discussions around “hiring” slowed, which is in line with some of the softness in the labour data seen recently.

That said, “layoff” mentions remain low relative to history.

“The consumer backdrop continues to be characterised as slowing, but not falling off materially; consumer services have seen more of the recent, incremental softness,” Mr Wilson said.

In regard to the US economic outlook, while ISM Services and weekly initial jobless claims data allayed the worst fears that emerged after the surprisingly weak ISM Manufacturing and non-farm payrolls data, Citi for one isn’t convinced that the soft landing script is intact.

The rise in the US unemployment rate to 4.3 per cent in July from 3.4 per cent in April 2023 is the “clearest sign yet that rather than achieving a soft landing the US economy is more likely to slide into recession”, according to Citi’s US chief economist, Andrew Hollenhorst.

“Attempts to explain away softer labour market data as a weather-related distortion are reminiscent of claims that elevated inflation would prove to be ‘transitory’,” he said.

Mr Hollenhorst argues that standard macroeconomics provides a more straightforward explanation – restrictive interest rates, fading fiscal stimulus, and exhausted excess savings are dampening demand, and firms are responding by reducing labour costs.

“Following the pattern from every prior business cycle, soft hiring, reduced working hours and ‘temporary layoffs’ are likely precursors to rising outright layoffs,” he said.

In terms of the stockmarket, RBC Capital Markets head of global equity strategy, Lori Calvasina, said last week’s extreme price action relieved some pressures on the stockmarket, but didn’t solve its major problems.

At least corporate earnings “remain solid with no major deterioration in corporate tone”.

However, like Morgan Stanley’s Wilson, Ms Calvasina advocates being “more selective” in portfolio allocations with a focus on “value-oriented defensive sectors” from here.

“We are optimistic that a short-term bottom was put in place, or came close to being put in place, on August 5th, when the S&P 500 closed down 8.5 per cent from its peak – within the range of a normal and healthy pullback of 5-10 per cent – and important technical support levels held,” she said

“But we remain on guard for choppy conditions to persist for a while longer and don’t rule out a growth scare or drawdown of 14-19 per cent, similar to the 2010, 2011, and 2015-2016 pullbacks if economic data releases continue to disappoint.”

For now, her 5700 year-end target stands, as while “none of the stockmarket’s problems were fully fixed last week, some pressure was released”.

Net bullish sentiment fell back into neutral territory, the median PE multiple of the top 10 names in the S&P 500 from about 32 times to 24 times, but remains well above its average of 18 times.

And the ISM Services and initial jobless claims data relieved some of the economic angst put in place by the weak ISM manufacturing and jobs reports the prior week.

But seasonality is negative for stocks and September – when many sell-side firms hold industry conferences – “will likely be a tricky time as companies tend to be reluctant to provide too much forward-looking commentary at this time of the year”, yet investors will be clamouring for information on business conditions and corporate expectations.

The US election, which tends to be accompanied by softness in equity markets in September-October, is another unresolved factor.

The US interest rate outlook will remain top of mind for investors, with Ms Calvasina noting a tendency of US equities to fall after the first Fed cuts in recent cycles.