Markets are responding to ‘fire and ice’ of inflation and slowing growth: Strategist

Morgan Stanley Chief Investment Officer Mike Wilson joins Yahoo Finance Live to discuss the market outlook for 2022, the Fed, inflation, and fourth quarter earnings.

Video Transcript

BRIAN SOZZI: The first strong market's start to the year hasn't been kind to the bulls, especially those dabbling in tech stocks as the NASDAQ has fallen into correction territory. Some pros on the street think this corrective period from markets has only just begun. Mike Wilson is the Chief Investment Officer and Chief US Equity Strategist at Morgan Stanley, and joins us now. Mike, always good to get some time with you here.

So you have consistently said you have been looking for a correction in the first half of this year. We have the NASDAQ down about 10% or so. The S&P 500 not down as much as the NASDAQ. How much further downside do you see?

MIKE WILSON: Yeah. Well, thanks for having me on, Brian. I mean, look, I think what we have to acknowledge is this correction in the indices really began a while ago. OK? And you could argue it began almost a year ago. That's when a lot of [AUDIO OUT] after the spring of 2021. I think it took on another flavor, another level of correction when the Fed started to pivot its policy in early November. And that was right after Chair Powell was renominated, and I think the market started to figure out that this Fed was going to fight inflation and fight it aggressively. And I think that the markets to joke on that.

And so really, since early November, you know, the growth stocks have taken the most pain. That's really part of our two-stage corrective view. OK? We call it "fire and ice." The fire is essentially what we've already seen, which is inflation got out of control, and now the Fed is having to respond to that. And that's having a negative impact on valuations, particularly the most expensive ones. That's good. That means that the market gets the joke, and it's discounted some of that.

The second part of the narrative, though, which I don't think is really over and probably hasn't even begun yet, is that we're seeing a slowdown in growth. I think people appreciate that. And our view is just that it's going to slow more than what is modeled, both from an economic and an earnings standpoint. And there's really two or three reasons for why we're a bit more pessimistic on growth in the near term. And the first one, of course, is that fiscal stimulus is fading. Second one is that there's a payback in demand for things that were over-consumed during the pandemic. And then the third one is margins and profitability because, obviously, these costs are now eating into profitability, so that has to play through.

We think it'll be basically over by the second quarter. We don't know exactly what month, obviously, it's difficult to predict. But I would say another 10% downside for the major averages because they really haven't corrected yet. While the average stock has seen quite a bit of downside, the major averages still have a good 10% down from here in my view. And then that sets us up for really a pretty good second half, quite frankly, because Omicron's fading, and the rest of the world is going to have a pretty powerful recovery in the second half of this year.

JULIE HYMAN: Hey, Mike. It's Julie here. We have definitely noticed as we've been getting some early guidance from companies on earnings from last quarter an uptick in companies coming out with negative guidance. And you had a chart in your latest report that really put a fine point on that. That we have been seeing the negative revisions-- or, really, come up, and so positivity go down. What are you going to be looking to hear from companies this quarter? What questions do you want answered that are going to let you know kind of just how bad things are out there?

MIKE WILSON: Yeah. I mean, I think it's going to be really mixed, really. I don't think every company is going to suffer through this period. It's going to come down to execution, right? I mean, some companies are actually benefiting from the trends that we're seeing. They have pricing power, they can pass it right along, you know, some things are going to stay high in demand. And then other companies, probably the lower-quality operators, are going to really struggle here, whether it's with labor costs, supply chain constraints, logistics, et cetera. And then just flat-out missing sales because they underestimated the payback in demand.

And so it's just going to be messy. So what we want to see is we just want to see expectations come down either via price or via earnings forecasts. And if that happens, then we'll feel more comfortable. Right now, we think a lot of margin assumptions are unachievable, so we want to see margins come down, and we want-- we think valuations are unsustainably high still at the index level. Just to give you some numbers, 20, 21 times is kind of where we're trading on forward 12-month earnings for S&P. You know, the more realistic sort of valuation metric we think is 18 times. And we know that's a bit of a sort of black magic art more than science. But we have some pretty good models that tell us that 18 times is the right number.

So let's see that come down, let's see the revisions kind of come down, and then we'll reevaluate.

JULIE HYMAN: And Mike, in sort of a concrete way, is it-- what's going to be the biggest obstacle here? Is it going to be inflation for these companies and their-- the sort of varying ability of them to pass on costs? It doesn't feel like that the demand side of the equation is the problem.

MIKE WILSON: Yeah, it doesn't right now. I think that is common wisdom that basically, it's a supply problem, not a demand problem. But we don't agree with that at all. We think that essentially, the supply shortages have led to an abundance of over-ordering, OK? Double-ordering, whatever you want to call it. And as supply picks up, which it's now. That's what we're starting to hear, of course, that supply is getting better, normally what happens is we see orders get canceled, right? So as people get enough product, they start to then cancel those orders. And that's the next stage.

So we think demand is actually overstated [AUDIO OUT] industry. There are some businesses clearly where there's pent-up demand still. Maybe that's in consumer services, health care services, things that people weren't able to consume, obviously, during the pandemic. And look, once again, I think Omicron is, you know, it's a good sign that basically the hospitalization and mortality rates are much, much lower. So I'm very optimistic that we're going to see the end of this pandemic sometime this spring.

But with that comes better supply, which means then the double-ordering gets revealed. OK? So that's where we've got to be, I think, focused on here for the next couple of quarters.

BRIAN SOZZI: Mike, you've seen a good number of investing cycles in your time. And the way I think about it, over the next six months, you're going to see the Fed wind down its balance sheet, potentially hike rates four times. And you know what? So what? We see the NASDAQ down about 10% right now, it doesn't strike me as a major correction. Why are investors so complacent heading into really a clear shift by the Federal Reserve?

MIKE WILSON: Well, I think they were complacent. I don't think people are complacent now. I think the Fed has made it crystal clear through their communications recently that they mean business. I don't think that complacency is nearly where it was two or three months ago. But look, this is what financial repression for a better part of 15 years has done, right? I mean, the Fed has been overgenerous with policy during this period, and so people have become used to that. And so now this pivot has come out and so quickly, that's why the adjustments, you know, are happening rapidly.

And that probably is not over with, meaning there is a new regime. There's a new Fed in town because they've had success. I mean, let's not forget, part of the reason why they're tightening is because they've had more success than they imagined. They got more inflation than they dreamed of. That's good on one hand, that means we're getting out of the secular stagnation. That means growth can be good. But what you pay for that growth now is under question if rates are going to be higher down the road. And that's the main issue. It's not about rates being at 180 today or 175. It's where our rates are going to be in five years, right?

When you're investing in stocks or other long-duration assets, you know, you have to make an assumption about where rates are going to be over the investment time frame, over the next 10 years. And I would say the odds of interest rates being higher, cost of capital being higher over the next 10 years has gone up materially with the Fed's success. And that's the sort of point of recognition that has really come upon the market so quickly here.

JULIE HYMAN: So Mike, if you're not going to get returned from the broad stock market here. You know, and again, to remind folks, your year-end target for the S&P is 4,400. Where are you going to get it? Where are you looking for return this year?

MIKE WILSON: Well, I mean, it's at the stock selection level. I do think this is the year of the stock picker, and I think clearly you need to see, you know, certain-- you need to pick stocks, basically. Pick the winners, which is not impossible, but it is harder in a world where the overall averages are flat to down for the year. Now look, we're still fully invested because, you know, we still think stocks over the investable time frame, call it three to five years, are still going to be the better place to be.

So part of this is just a digestion period, too, Julie. I mean, we've gorged on returns for the better part of two or three years, not to mention the past decade. So some of this is just payback, you know, and basically, people having to just buy some time in here. You're still getting in about a 2% dividend yield on the major averages. Some stocks are paying dividend yields at 3%, 4%, 5%, and they're growing. So that's part of your return, and that return is still going to be there because we think earnings are going to be fine and the ability to pay dividends is going to continue. So it's not uninvestable, OK?

There are also many individual stocks that have underperformed for years that are starting to come back to life, whether that's in energy, some of the financial sectors, some of the international markets, perhaps, emerging markets could come back to life if we're right about the second half of this year. So we just think that this one sort of decision, buy it and forget it with compound or growth stocks-- I mean, that was a great trade, and it was a great investment theme. But now you need to think away from that and there are other things to do.

BRIAN SOZZI: Second half of the year, can't get here quick enough. Mike Wilson, Chief Investment Officer and Chief US Equity Strategist at Morgan Stanley. Always nice to see you. Have a great rest of the week.

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