The Six Largest Wall Street Banks Issue Market Red Alerts
Morgan Stanley, Bank of America, Deutsche Bank, Citigroup, Credit Suisse And Goldman Sachs.
These are some of the biggest Wall Street banks that have issued “red alert” warnings on the US stock market in just the past few days, with some expecting an imminent correction of 10-20%, while others expect a slow burning drift lower over the next few months. Below we summarize the highlights of their surprisingly downbeat views.
We start with Morgan Stanley, which yesterday published its latest Global Macro Forum slide deck (available for professional subscribers), and where the bank’s chief cross-asset strategist Andrew Sheets warns that equity market internals have continued to follow a “mid cycle transition”, a process which usually ends with quality stocks – like the FAAMGs market “generals” – getting hit, “which poses outsized risk to the high-quality S&P 500” through October.
Sheets frames his pessimistic view by disclosing the five themes which he believes will define markets though year-end. These are:
Policy divergence and the start of tapering: MS expects the Fed to signal its intent to taper at the September meeting. As central bank policy becomes less easy, it also becomes more divergent. This will provide support for long DXY, short PLN/HUF, short US duration and gold, caution on US and Taiwan equities.
Vaccination divergence: The world has two strategies to combat COVID-19 – vaccination and suppression. The Delta variant has made the latter difficult, increasing risks to growth in regions with low vaccination rates. The bank sees this as bullish for EU equities.
Valuation divergence: 2021 to date has seen a wide adjustment in valuations. Sheets’ advice: “Focus on areas with greater levels of valuation adjustment. We add Brazil versus EM equities to our top trades.”
Echoes of 2004: Sheets thinks that 2004 offers a useful guide for a ‘mid-cycle transition’. He suggests taking default risk over spread risk and like loans over bonds in credit.
Doing things > buying things: The pandemic saw demand for goods jump and demand for services collapse. As the recovery continues, expect a reversal. We think this supports energy > metals, and are cautious on US consumer discretionary.
While regular readers are aware of Morgan Stanley’s long-running theme that the US economy is undergoing a mid-cycle transition, for those unfamiliar, here is one way that the bank’s chief equity strategist Michael Wilson has framed it previously, showing that the ISM Manufacturing Index always lags the Prices Paid, which has recently reversed (shown inverted on the chart below) and suggests of significant downside tot he closely watched indicator.
As part of this “mid-cycle transition”, several months ago the bank urged clients to transition out of small caps and into quality stocks…
… we are now on the verge of ending the mid-cycle transition, which according to Michael Wilson ends either in “fire,” with a market correction of 10-20% as a result of higher rates…
… or “ice” as consumer spending grinds to a halt.
Putting it together, Andrew Sheets lists the following 5 key market takeaways:
September and October represents a tricky period for central bank communication, economic data and market technicals: The bank sees risks to both US equities and US bonds given current valuations, and as a result Morgan Stanley is downgrading US stocks to Underweight and global equities to Equal Weight.
For the global economy, Morgan Stanley thinks that many current inflationary pressures are temporary, but the timing of peak inflation varies by region and country. On growth, the bank believes that “we’ve passed the peak in activity, with August particularly weak in the US, but the end of the cycle is not nigh.”
In rates, it will come as no surprise that MS thinks that core rates have bottomed and will move higher into 4Q21 and into 2H22, after all this is the biggest consensus trade across Wall Street (and is thus likely wrong): Central bank withdrawal of policy accommodation and a near-term trough in economic data should both help to push yields higher. Sheets also thinks USD also grinds higher into year-end.
For equities, Sheets warns that market internals have continued to follow a ‘mid-cycle transition’: That process, as noted above, usually ends with quality stocks getting hit, which poses outsized risk to the high-quality S&P 500. Both ‘fire’ (rates higher) and ‘ice’ (the growth slowdown is worse than expected) pose risk to a market that has barely de-rated year-to-date.
Putting it all together, on Wednesday morning Sheets spoke to Bloomberg TV, saying that “we are going to have a period where data is going to be weak in September at the time when you have a heightened risk of delta variant and school reopening” adding that “If the data does stay soft, the market valuations just haven’t adjusted like other parts of the market have.”
Bank of America
Regular readers will know that Bank of America has been one of the most bearish big banks in 2021, with its Chief Investment Officer spouting a weekly dose of fire and brimstone (as an example see his “Bear Case In 12 “Charts Of Darkness“), while the bank’s chief equity strategist Savita Subramanian having held to the lowest 2021 year-end S&P price target at just 3,800, tied with Stifel’s Barry Bannister for most bearish strategist.
Well that changed today, when just like Michael Wilson a few weeks ago, she finally hiked her year-end S&P price target to 4,250 from 3,800, admitting that she is “marking our models to market”, i.e., merely catching up with stocks, i.e., the Fed’s balance sheet, but not before warning that “downside risks remain” and asking “what good news is left?” Indeed, while higher, her new price target still implies 6% downside from current prices. The table below reveals how she got to that particular price, and also how Subramanian got her 2022 year-end S&P price target of 4,600… which is just 2% higher from spot.
But far from turning bullish, her note published this morning titled “Should you keep dancing if the music slows down?” (available for professional subscribers) is a scathing critique of everything that is broken with the market, and a cautionary tale to anyone who believes that buying the S&P at its all time high of 4,500 is a good idea.
Next, Subramanian warns that “sentiment is all but euphoric with our Sell Side Indicator (see SSI) closer to a sell signal than at any point since 2007″…
… an indicator which explains 25% of subsequent S&P500 returns…
… while wage/input cost inflation and supply chain shifts are starting to weigh on margins.
The BofA strategist also calculates that interest rate risk is at a record high, with S&P 500 equity duration equivalent to a 36-year zero-coupon bond, where every 10bp increase in the discount rate equates to a 4% decline. Finally, “valuations leave no margin for error.”
Having reluctantly hiked the price target, Subramanian – like Wilson – is quick to caution that “this may not end now. But when it ends, it could end badly.”
If taper means no upside to the S&P 500, tightening would be worse. Canaries are chirping – PPG, a barometer of industrial activity, aborted guidance on supply chain woes; credit spreads have stealthily widened, and our valuation model (~80% explanatory power for S&P 10yr returns) now indicates negative returns (-0.8% p.a.) for the first time since ‘99.
As noted above, Subramanian also looked at one of her favorite indicators – price to normalized earnings – which has a very strong relationship to subsequent S&P 500 returns over the long haul. With the S&P 500 current sporting a trailing normalized PE ratio of 29x, the BofA strategist calculates that the 10-year annual 12-month price return of -0.8%, “represents the first negative returns since the Tech Bubble.” In other words, ten years from now stocks will be… lower than where they are now.
While not nearly as bearish as Morgan Stanley (and its equity Underweight rating) or Bank of America (with its gloomy near-term and 10 year forecasts), Deutsche Bank has also joined the bandwagon of bears, and in the bank’s latest House View (available for professional subscribers), titled “The New World: Moving Beyond Covid”, the bank writes that “the global economy performed strongly over the summer, but the delta variant has led to increasingly frequent data misses versus expectations. This has seen us downgrade our near-term US growth outlook just as high inflation readings have shifted attention to when central banks will taper asset purchases.”
Looking ahead, DB notes that while tapering discussions will raise the stakes for this month’s Fed and ECB decisions but “September will see other pivotal events for the outlook too. The German election has tightened up significantly, and polls suggest that only three-party coalitions can form a majority, meaning negotiations could take some months. US government funding runs out on September 30, and a potential fight over the debt ceiling is approaching. Furthermore, the House will vote on the bipartisan infrastructure bill by September 27, and we should soon find out the next Fed Chair.”
ANd while financial markets have remained buoyant, and equity indices have repeatedly hit fresh highs, Deutsche Bank’s strategists “expect an imminent correction” even though they see the S&P 500 rising back around current levels by year end.
Some more details on the coming pullback in markets which DB believes will see the S&P drop 6%-10%:
Indicators of macro cyclical growth are peaking and data surprises are now negative
Earnings upgrades are likely done as the bottom up consensus has upgraded forward estimates significantly.
Inflation risks are rising.
And overall positioning is high while the retail investor is in retreat, though buybacks and inflows are still strong.
But, as noted above, and in seeking to break from the uber-bears, DB notes that it then sees equities rallying back as its baseline remains for strong growth but only a gradual and modest rise in inflation.
The summary of the bank’s market views is below:
Perhaps the most cheerful take of all, came from Goldman’s Christian Mueller-Glissmann, who in a Bloomberg interview echoed what we first observed a few weeks ago, namely that “High valuations have increased market fragility,” adding that “if there is a new negative development, it could generate growth shocks that lead to rapid de-risking.”
“The key point here is there is very little buffer left if you get large negative surprises,” said Mueller-Glissmann.
Writing in a GOAL Kickstart note on Tuesday (available for professional subscribers) Mueller-Glissman said that “the S&P 500 has continued to make all-time highs despite the weaker macro. In fact, realized vol dipped to 8% during the summer pointing towards a new low vol regime, resulting in particularly strong risk-adjusted returns. After the clear ‘good news is good news’ regime in Q1, for the S&P 500 ‘bad news’ has become ‘good news’ again last quarter.”
This, the Goldman strategist notes, “is consistent with more support from dovish ‘monetary policy’ or search for yield: long-duration secular growth stocks have been boosted by the decline in real yields, helping broad indices which now have a larger weight in these stocks.”
Meanwhile, dissecting macro surprises shows that while global MAP scores were still positive until recently, the US MAP turned negative, led by labor data while consumer and manufacturing held up better. All in all this has supported dovish Fed policy expectations creating a ‘Goldilocks’ backdrop .
However, as Goldman warns, “more recently macro surprises have also turned more negative across the board.” During periods of negative macro surprises the right tail risk for equities has historically been more limited – average returns and hit ratios for the S&P 500 tend to be lower. Option markets have reflected this – for the next 3m the likelihood of very positive S&P 500 returns (above 8%) is priced lower than normal, even lower than during slowdown phases. On the other hand, Mueller-Glissman notes that the likelihood of a 5% S&P 500 rally is still elevated compared to the average during low vol regimes.
Meanwhile, the recent low realized volatility has pushed the volatility risk premium close to the post-2000s highs and Goldman’s options research team expects realized volatility until the end of the year to be lower than what is implied.
The conclusion: “With equities close to all-time highs, elevated equity valuations and a less favorable growth/inflation mix near term, call overwriting can still be attractive as a carry overlay.”
The threat of growing market fragility was also touched upon by Citi’s Chris Montagu who in his latest Viewpoint note, wrote that investor positioning has become ultra-bullish, with longs on the S&P 500 outnumbering shorts by nearly 10 to 1. In his view, half of those bets are likely to face losses on a drop in the index of as little as 2.2%. And even a small correction could be amplified by forced long liquidation.
As Montagu observes, the main equity indexes continue to set new highs, but the underlying positioning differs greatly by region. US equity positioning is extended and very one-sided net long, which leads to asymmetric risk of positioning amplifying any small market correction. Investors continue to add to this long bias. Meanwhile, positioning is much lighter in Europe and less likely to significantly drive price action near term. In Japan the recent rally in Nikkei 225 initially only saw limited investor participation, but there are signs that futures investor flows are accelerating even as ETFs continue to see modest outflows.
Focusing just on the US, Montagu writes that “investors have steadily been adding to net long exposure throughout the summer” and remain very long. Meanwhile, if one includes “legacy” positions and in particular the large swing towards net longer around the June FOMC meeting, then positioning looks even more extended as “investors continued to add to the long bias last week, but only at the moderate steady rate seen throughout the rest of the summer.”
WIth that in mind, Montagu warns that “risk is asymmetric to the downside with crowded positioning in the form of longs outnumbering shorts nearly 10 to 1.” According to his calculations “these longs sit on an average 2.4% profit and half of positions in loss on a move below 4,435 (~2.2% correction). That means a small correction could be amplified by forced long liquidation pushing the market further down.“
Finally, the Nasdaq is similarly stretched with the concentration of long positions leaving the market more vulnerable on a sell-off, and while older positions sit on large profits which act as a buffer on minor volatility, “nearly a quarter of positions are more recent and with no profit buffer.”
In short, one serious swoon lower could quickly transform into a rout.
We round out the gloomish bank compendium by skimming the latest note from Credit Suisse equity strategist Andrew Garthwaite who while turned bearish on U.S. equities while predicting that rising bond yields and inflation expectations are likely to help European equities outperform their regional peers.
Europe’s PMI momentum is “much better than in the U.S., and markets have unusually decoupled from this,” Garthwaite said, while noting that he is “small underweight” on U.S. equities as tax and regulations pose a higher risk than other regions, and points to “extreme” valuations.
* * *
So is a correction, or perhaps even bear market, assured? Of course not, and there are two key catalysts that could prevent such an outcome, besides the Fed of course. On one hand, banks can unleash another record burst of stock buybacks as they did three weeks ago just as stocks were about to breach the key 4,350 support level. And then, there is the continued risk appetite among retail investors.
In his latest Flows and Liquidity notes, JPM quant Nick Panigirtzoglou saw retail investors as the key force behind recent gains, noting that they plowed almost $30 billion of cash into US stocks and ETFs in July and August, the most in a two-month period. And it is these retail investors – whose performance has trounced that of hedge funds in the past two years, that could also be the support pillar that keeps the market stable, as long as easy money policies persist, according to JPM.
“Retail investors have been buying stocks and equity funds at such a steady and strong pace that makes an equity correction looking rather unlikely,” JPMorgan global strategists including Nikolaos Panigirtzoglou wrote in a Sept. 1 note. “Whether the coming Fed policy change changes retail investors’ attitude towards equities remains to be seen.”
“So far this year retail investors have been buying stocks and equity funds at such a steady and strong pace that makes an equity correction looking rather unlikely” Panigirtzoglou wrote, adding that “whether the coming Fed policy change changes retail investors’ attitude towards equities remains to be seen.”
At the same time, he also concedes the counter argument “that the strength of the retail flow has pushed equities up by so much and has made investors globally more overweight equities, many of them unwilling, that the risk of profit taking should be naturally high. Indeed, in support of this counter argument, updating our most holistic of our equity position indicators, i.e. the implied equity allocation of non-bank investors globally, points to an equity allocation of 46% currently, only slightly below the post Lehman crisis high of 47.6% seen in 2018”
And while the JPM quant admits that he is sympathetic to this counter argument, “in the absence of a material slowing in the retail flow into equities, the risk of an equity correction remains low.” As such, in his view monitoring this retail flow on a daily and weekly basis going forward “is key to the equity market outlook.”
And since JPMorgan knows this, the Fed certainly knows this, and we are confident that even the smallest market hiccup will prompt a furious response at the Marriner Eccles building, because we are now well beyond the point of no return and Jerome Powell and company simply can not afford even the smallest drop in stocks without risking a full-blown market meltdown, much to the chagrin of the banks above who are predicting just that.
Thu, 09/09/2021 – 04:33