Chasing the End of the Economic Cycle

As the current economic cycle plays out, history suggests that stock prices could be in for large price swings in both directions.

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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 you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 22nd at 11am in New York. So let's get after it.

For the past several weeks, we've engaged with many clients from very different disciplines about our outlook for 2024. From these conversations, the primary takeaway is that there isn't much conviction about how this year will play out or how to position one's portfolio. After one of the biggest rallies in history in both bonds and stocks to finish the year, there's a sense that markets need to take a rest before the next theme emerges. Our view isn't that different, except that from our perspective, not much has changed from three months ago other than the price of most assets.

In our view, we remain very much in a late cycle environment, during which markets will oscillate between good and bad outcomes for the economy. The data continue to support this view, with both positive and negative reports on the economy, earnings and other risk factors. However, as noted, the price of assets are materially higher than three months ago, mainly due to the Fed's pivot from higher for longer, to we're done hiking and likely to be easing in 2024. In addition to the timing and pace of interest rate cuts, investors are also starting to ponder if and when the Fed will end its quantitative tightening or QT campaign. Since embarking on this latest round of QT, the Fed's balance sheet has shrunk by approximately $1.5 trillion. However, it's still $500 billion above the June 2020 levels immediately after the $3 trillion surge to offset the Covid lockdowns. To say that the Fed's balance sheet is normalized to desirable levels is debatable. Nevertheless, our economists and rate strategists think the fed will begin to taper the QT efforts starting sometime this summer. More importantly, we think equity prices now reflect this pivot, and the jury is out on whether it will actually increase the pace of growth and prevent a recession this year.

Three weeks ago, we published our first note of the year, laying out what we think are three equally likely macro scenarios this year that have very different implications for asset markets. The first scenario is a soft landing with below potential GDP growth and falling inflation. Based on published sell side forecasts and discussions with clients, this is the consensus view, although lower than typical consensus probability of occurring. The second outcome is a soft landing with accelerating growth and stickier inflation, and the third outcome is a hard landing. There's been very little pushback to our suggestion of these three scenarios with equally likely probabilities, and why clients are not that convinced about the next move for asset markets, or what leads and lags. As an aside, this isn't that different from last year's late cycle backdrop, when macro events dictated several large swings in equity prices both up and down. We expect more of the same in 2024. While stock picking is always important, macro will likely remain a primary focus for the direction of the average stock price.

In our view, the data tells us it's late cycle and the Fed will be easing this year. Under such conditions, quality growth outperforms just like last year. While lower quality cyclicals outperformed during the final two months of 2023, we believe this was mainly due to short covering and performance chasing into year end, rather than a more sustainable change in leadership based on a full reset in the cycle, like 1994. So far in 2024, that's exactly what's happened. The laggards of 2023 are back to lagging and the winners are back to winning. When in doubt, it pays to go with the highest probability winner. In this case it's high quality and defensive growth which will do best under two of the three macro scenarios we think are most likely to pan out this year.

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