WHERE ARE WE IN THE TIGHTENING PHASE?

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WHERE ARE WE IN THE TIGHTENING PHASE?
25 February 2010 by TPC

The Fed’s surprise discount rate move has investors searching for reassurance on the  interest rate outlook.  Yesterday’s comments from Ben Bernanke were enough to spark a 1% rally in the equity markets based on the hope that the Fed will remain accommodative for many more months.  Morgan Stanley’s equity team says this bullishness is unwarranted.  They believe the global equity tightening phase has already started and the United States is simply lagging.  As we mentioned last week, MS recommends selling rallies during the tightening phase (see the full year bearish 2010 outlook from MS here).  As the global tightening phase deepens they fear a “growth  scare” could develop:

    “From ‘start of tightening’ to ‘growth scare’.  While leading indicators are rolling over, we expect a period of lower growth prospects, higher uncertainty and possibly higher rates as overheating fears in Asia, start of Fed exit in the US, and sovereign trouble in Europe will dominate.  Our 10% 2011 EPS growth estimate for Europe is below the 24% consensus estimate.

    Sell the rallies until fundamentals improve, or our indicators say ‘buy’. Fundamentals should improve, we think, when Asian inflation pressures ease, the Fed language change has happened, and sovereign contagion risks recede.”

Historically, the beginning of tightening phases have resulted in several quarters of equity market weakness.  Using the 1994 and 2004 recoveries as framework MS finds that double digit corrections were characteristics of both tightening phases.

    “We have found that this ‘start of tightening’ phase coming out of a recession (such as 1994, 2004) always leads to a period of 2-3 quarters of struggling equities, including a double-digit correction.  This is now morphing into a growth scare, we believe.  Our earnings growth leading indicator still suggests strong growth in 2010, but we expect 2011 EPS growth to disappoint at 10% versus consensus expectations of 24%.   In addition, leading indicators are peaking out and rolling over right now.  This is typically followed by struggling equity markets.”

On a more macro level they continue to believe the secular bear is alive and well and now see 5 themes that could coincide with the next global recession:

    “We think the secular bear market that started in 2000 is still due its final leg, in the next global recession.  This next global recession is up to a few years away still, we think, when EM/China growth falters, although sovereign contagion could cause the next global recession sooner.  The next recession could involve problems relating to high inflation, sovereign funding in G7 countries, a China recession, a much higher gold price, and the Shiller P/E undershoot that did not happen in 2008/09.”

Based on this overall outlook Morgan Stanley believes investors should continue to sell the rallies until equities correct to a more attractive level:

    Sell the rallies … We believe 1994 and 2004 are recent years that were similar to what we expect to go through this year. Equities had many ‘swings and roundabouts’ those years, but the right strategy was to sell the rallies when the tightening and growth scare phase had started, which we believe was in
    mid-January.

Source: Morgan Stanley

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