V-shaped recovery likely, but correction likely first: Morgan Stanley 8 Jun 2020

Since late March, I've taken an optimistic view of equity markets for the following reasons. First, bear markets end, rather than begin, with recessions. Second, the health crisis that triggered this recession has brought unprecedented monetary and fiscal stimulus that would otherwise have been impossible. Three, the political pressures behind the reopening of the U.S. economy are likely to make it faster and more durable, even if a second wave of the virus emerges. Four, sentiment and positioning have remained remarkably bearish considering the size and persistence of the equity rally to date. And finally, index prices, the equity risk premium, market breath, and early cycle leadership are all following the same pattern we witnessed at the 2009 bottom during the Great Financial Crisis. In short, our recession playbook is working.

Having said that, a few signals have been missing that would support a continued bullish outlook for equities. Specifically, the U.S. dollar has remained strong and the 10 year Treasury yields remain depressed. While one could argue that a strong U.S. dollar benefits U.S. equity markets through flows and lower interest rates support valuations, our contention is that both are bad signs for the economic recovery. Therefore, we were glad to see both a weaker dollar and higher back-end rates last week, even before the stronger jobs data were released on Friday morning. In fact, both have moved above some key resistance levels left over from April. This combination provides a missing signal for two critical macro markets that a V shape recovery is, in fact, looking more likely.

It also matters because we continue to hear concerns from investors that equity markets appear disconnected from reality. One argument in support of this view is that longer term Treasury yields haven't budged and the bond market is smarter than the equity market when it comes to forecasting the economy. However, a good part of my investment framework is based on analyzing the internals of the equity market-- in other words, how sectors and styles and factors are behaving, rather than just looking at the headline index. These signals contain a tremendous amount of information, and I've found them to be helpful in forecasting real economic activity. One of my favorite stock ratios tracks how cyclical stocks trade relative to defensive ones. This ratio has been an excellent leading indicator for economic growth, often better than Treasury yields.

In 2018, for example, this ratio proved to be timely in calling the peak rate of change in the U.S. economy. It even foreshadowed the top in long term interest rates at a time when the consensus was bearish on Treasury bonds. In other words, equity market internals did a better job than the bond market in calling the top of the economic cycle. Now we find ourselves in the exact opposite situation. The stock market is rallying strongly, led by cyclicals. However, bond yields have lagged and failed to confirm the signal from stocks until this past week. The divergence between our cyclical and defensive equity ratio and the 10 year yield hasn't been this wide since 2018, right before yields unexpectedly collapsed. Could this be the turning point for 10 year yields to move sustainably higher at a time when the consensus least expects it? Based on our interpretation of the equity market internals, there's a good chance it is. We also think sharply rising yields could have implications for equity portfolios, and the kind of rise in yields suggested by our cyclical defensive ratio would qualify as sharp.

If interest rates quickly catch up to cyclical stocks, it may be a temporary negative for equity indices as valuations come under pressure. Such a rerating would likely be most damaging to the bond proxies like utilities and consumer staples, and the most expensive growth stocks which make up a large percentage of the index. However, after a period of adjustment, a move higher in rates should ultimately be interpreted as another sign of better growth to come. The bottom line, equity markets have been telling us growth is going to surprise on the upside. Interest rate markets have lagged this move in equities, but could quickly catch up. A sudden, sharp move would likely cause a correction in the equity market, but I'd view it as just a bump in the road of this new bull market and an opportunity to add risk, especially in the more economically sensitive areas that have been leading.