A Longer Wait for Rate Cuts?

As positive economic data makes it less likely that the Fed will cut rates in March, our Chief US Equity Strategist explains what this could mean for small-cap stocks.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U. S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, February 5th at 11 am in New York.

So let's get after it.

Going into the last week, investors had a number of factors to consider. The busiest week of earnings season that included several mega cap tech stocks, a Fed meeting, and some of the most relevant monthly economic data for markets. Around these data releases, we saw significant moves in many macro markets, as well as individual securities.

We started the week with a soft Dallas Fed Manufacturing Index reading, which followed the weak New York Manufacturing Survey two weeks earlier. Meanwhile, the Conference Board Consumer Confidence Index and the University of Michigan Consumer Sentiment Survey both pushed higher.

As the week progressed, we got more data that supported the view that the economy may not be slowing as much as many had started to believe, including perhaps the Fed. In contrast to the Dallas and New York Fed Manufacturing Surveys, The ISM manufacturing PMI ticked higher, and surprised to the upside by a few points.

More importantly, the orders component ticked above 50 to 52, which tends to lead the headline index. The fact that the overall equity market responded favorably to these data makes sense in the context of still present growth uncertainty. However, the fact that cyclical stocks that are levered to manufacturing continue to underperform tells me the market is still very undecided about the macro outcome this year -- as am I.

Finally, the headline non-farm payrolls number on Friday was extremely strong at 353, 000. Manufacturing jobs surprised to the upside, giving credence to the uptick in the ISM Manufacturing PMI cited earlier. However, the release also incorporated the annual revisions, which may be overstating the strength in labor markets.

Employment trends from the Household Survey remain much softer, as do hours worked, quit rates, and layoff announcements. In short, the labor market is fine, but still weakening, as desired by the Fed. The one area of unequivocal strength remains government spending and hiring, which could be working against the Fed's goals.

The bond market went with the stronger read of the data and traded sharply lower on Friday, as so this morning. It has also pushed out the timing of the first Fed interest rate cut, taking the odds of a March cut all the way down to just 20 per cent. Recall this probability was as high as 90 per cent around the end of last year.

Perhaps the market is starting to take the Fed at its word. They aren't planning to cut rates in March. The equity market tried to look through this rate move on Friday driven by a historically narrow move in large cap quality growth stocks. This is very much in line with our recommendation since the beginning of the year to stick with large cap quality growth.

For now, the internals of the stock market appear to agree with our view that a stickier rate backdrop is a disproportionate headwind for stocks with poor balance sheets and a lack of pricing power. In other words, lower quality cyclicals and many areas of small caps. Perhaps the most important data to support this conclusion is that earnings results and prospects for 2024 remain weak for these kinds of companies.

On this front, we continue to get questions from investors on what it will take for small caps to work from here on a relative basis. The Russell 2000, the small cap index, has underperformed the S&P 500 by 7 per cent year to date and is still more than 20 per cent below all time highs reached over two years ago.

While some think this is an opportunity, our view is that we need more confirmation that we're headed for a higher nominal growth regime driven more by the private economy rather than inefficient government spending.

As we've discussed in the past, small caps are particularly economically sensitive and reliant on pricing power to offset their lack of scale.

As they await more definitive confirmation on whether a higher nominal growth environment is coming, small caps are being weighed down by a weakening margin profile, higher leverage, and borrowing costs. In short, stick with what works in a late cycle environment where the macro remains uncertain. Large cap, high quality growth.

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