A potential recession this year or next is not the worst thing in the world.
That’s according to Mike Wilson, the chief US equity strategist at Morgan Stanley, who is instead pointing investors in the direction of money-making opportunities.
Simply put, Wilson’s advice to clients is that when the agony of a recession reaches its boiling point, cyclical stocks will be a good buy.
This may appear counterintuitive upon first blush because cyclicals, by definition, track the fate of the economy. If growth is slowing, one might think they’d get hurt. However, Wilson’s examination of how investors are already bracing for a recession suggests that the opposite is occurring.
He observed that over the past three to six months, as fears of a slowdown mounted, investors overly skewed their positioning into defensively aligned sectors.
The rush for safety has come at the expense of cyclical sectors. For example, Wilson observed that just about one-fifth of momentum strategies on the long side are in consumer staples, but almost one-third of the short side is in energy.
Another way to quantify this widespread risk-averse behavior is by looking at traders’ expectations for the Federal Reserve. They’re pricing in no greater than an 18% chance that the central bank will raise interest rates this year, according to Bloomberg’s world interest rate probability.
Meanwhile, Morgan Stanley’s index of the market implied rate pace of rate hikes is at its lowest level since March 2008, when the Fed was cutting rates in the last recession.
This skew towards defensiveness suggests that investors have already priced in a lot of the bad news to come. If the S&P 500 falls to its December lows, “we would be buyers of that almost regardless of what’s going on, assuming it happens on less momentum and better breadth,” Wilson said.
Such a move would be part of a “rolling bottom” that occurs before the next bull market begins, he added. And so, the segments of the market that tend to do well early-cycle will benefit once investors price in a recession.
There are valid reasons to expect that this process of pricing in a recession is not yet complete and that stocks will fall further. Crucially, earnings season begins in earnest this week and is expected to confirm the bad news that companies like Apple have warned about. Morgan Stanley is going one step further and forecasting an outright earnings recession this year.
Even if it doesn’t morph into a full-blown economic crisis, an earnings recession will feel just as crippling for equity investors, Wilson said. The associated dip in stocks below December 2018 levels would be an opportune time to buy cyclicals, which typically benefit from upswings.