Our CIO and Chief US Equity Strategist explains why there’s pressure for the August jobs report to come in strong -- and what may happen to the market if it doesn’t.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the importance of economic data on asset prices in the near term.
It's Tuesday, Aug 27th at 11:30am in New York.
So let’s get after it.
The stock rally off the August 5th lows has coincided with some better-than-expected economic data led by jobless claims and the ISM services purchasing manager survey. This price action supports the idea that risk assets should continue to trade with the high frequency growth data in the near term. Should the growth data continue to improve, the market can stay above the fair value range we had previously identified of 5,000-5,400 on the S&P 500.
In my view, the true test for the market though will be the August jobs report on September 6th.
A stronger than expected payroll number and lower unemployment rate will provide confidence to the market that growth risks have subsided for now. Another weak report that leads to a further rise in the unemployment rate would likely lead to growth concerns quickly resurfacing and another correction like last month. On a concerning note, last week we got a larger than expected negative revision to the payroll data for the 12 months ended in March of this year. These revisions put even more pressure on the jobs report to come in stronger.
Meanwhile, the Bloomberg Economic Surprise Index has yet to reverse its downturn that began in April and cyclical stocks versus defensive ones remain in a downtrend. We think this supports the idea that until there is more evidence that growth is actually improving, it makes sense to favor defensive sectors in one's portfolio. Finally, while inflation data came in softer last week, we don't view that as a clear positive for lower quality cyclical stocks as it means pricing power is falling.
However, the good news on inflation did effectively confirm the Fed is going to begin cutting interest rates in September. At this point, the only debate is how much?
Over the last year, market expectations around the Fed's rate path have been volatile. At the beginning of the year, there were seven 25 basis points cuts priced into the curve for 2024 which were then almost completely priced out of the market by April. Currently, we have close to four cuts priced into the curve for the rest of this year followed by another five in 2025. There has been quite a bit of movement in bond market pricing this month as to whether it will be a 25 or 50 basis points cut when the Fed begins. More recently, the rates market has sided with a 25 basis points cut post the better-than-expected growth and inflation data points last week.
As we learned a couple of weeks ago, a 50 basis points cut may not be viewed favorably by the equity market if it comes alongside labor market weakness. Under such a scenario, cuts may no longer be viewed as insurance, but necessary to stave off hard landing risks. As a result, a series of 25 basis points cuts from here may be the sweet spot for equity multiples if it comes alongside stable growth.
The challenge is that at 21x earnings and consensus already expecting 10 percent earnings growth this year and 15 percent growth next year, a soft-landing outcome with very healthy earnings growth is priced. Furthermore, longer term rates have already been coming down since April in anticipation of this cutting cycle. Yet economic surprises have fallen and interest rate sensitive cyclical equities have underperformed. In my view this calls into question if rate cuts will change anything fundamentally.
The other side of the coin is that defensive equities remain in an uptrend on a relative basis, a dynamic that has coincided with normalization in the equity risk premium. In our view, we continue to see more opportunities under the surface of the market. As such, we continue to favor quality and defensive equities until we get more evidence that growth is clearly reaccelerating in a way that earnings forecasts can once again rise and surpass the lofty expectations already priced into valuations.
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