While not quite as damning as its 2018 credit forecast, Morgan Stanley's chief equity strategist Michael Wilson released his 2018 equity outlook this morning, and unlike his last full year forecast which in retrospect was surprisingly accurate, is far more contained, if not outright pessimistic. Wilson himself is quick to remark on just how much conditions have changed over the past 11 months:
At the beginning of the year, we titled our 2017 outlook "Are You Ready for Euphoria" on the basis that 1) Earnings growth was likely to accelerate sharply, 2) Financial conditions would remain very loose as the dollar weakened and long term interest rates remained "pinned" from ECB and BOJ purchases, and 3) Investor sentiment was too bearish about changing global politics and populist anti-trade "rhetoric." Fast forward to today and we find ourselves close to 180 degrees away from the conditions of 11 months ago. Specifically, we expect S&P 500 earnings growth to peak and financial conditions to tighten over the next 6 months while investor sentiment is no longer bearish with more investors now asking us about our "bull" case rather than our "bear" case and even contemplating the chance for a "melt-up." As an aside, we can't help but notice much more aggressive sell side 12 month price targets for the S&P 500 driven mostly by higher valuations – something most were citing as a reason to be bearish last year – even though valuations are 10 percent higher today! In short, we have made a lot of progress toward euphoria although retail inflows to US equities are still absent. We suspect that will change in 2018 if tax cuts are enacted helping us achieve our original 1Q2018 2700 target for the S&P 500.
With that in mind, Wilson notes that while we have yet to see the full blown Euphoria he called for at the beginning of the year, "we have definitely seen a significant improvement in sentiment, especially from institutional investors and our sell side strategist peers. The absence of strong and persistent equity flows from retail investors may be the final missing ingredient to conclude this cyclical bull market. We suspect that could happen in early 2018 with the signing of a tax bill."
As a result, Morgan Stanley's new year end 2018 base case price target for the S&P is 2750, barely changed from its 2,700 prior target, well below Goldman's 2,850, and curiously the strategist also echoes BofA's Michael Hartnett in stating that "we would not be surprised if we reach that target during 1H2018 and it marks the high for the year."
And while there is more in the full Wilson note, much of it similar to the warnings issued by Morgan Stanley in its credit outlook, one particular observation struck us: a curious correlation between volatility and the shape of the yield curve we had not seen anywhere previously.
In his discussion why Wilson expects bigger volatility in the coming year, and why he thinks "things will change in 2018" he shows the following chart which illustrates an interesting relationship between equity volatility and the economic cycle. It shows that the 2s-10s yield curve tends to lead the VIX by 2 ½ years. He explains:
You will notice that in the past 6 months, this impressive 25 year relationship has broken down with the VIX continuing to significantly fall even though the curve flattening that began 3 years ago would have suggested a rise by now. We think this is a reflection of the very supportive fundamental environment described above and the "give up" by traders who have succumbed to the trend and even turned to methodically selling volatility. Furthermore, many retail products have been created to sell vol and may have exacerbated the trend and overshoot to the downside. As economic data and earnings estimate dispersion increases next year, the underlying trend will likely reverse and these products will only serve to make the reversal more persistent than what we have experienced the past few years.
The chart Wilson is refering to is the following, and - as the Morgan Stanley strategists suggests - it should lead to a few sleepless nights for those who keep selling vol on even the smallest of VIX spikes. What it indicates is that if historical correlation is maintained, the VIX should be just shy of 30, a level which would have catastrophic consequences for virtually all vol-selling funds, including retail investors, active today.
Another way of visualizing this relationship, is courtesy of the following Bloomberg chart:
The chart above also shows that one potential pair trade for those waiting for the inevitable VIX mean-reversion is to go long the VIX while shorting the 2s10s and just wait for the compression.
And while correlation may not imply causation, Morgan Stanley lists 4 specifics reasons why it expects higher vol, and bigger drawdowns in the coming year, and why the VIX has seen its cycle lows:
Back in August when many market participants were worried about low volatility as we entered the seasonally weak time of the year, we made a case that equity volatility should be low and was not a sign of investor complacency. Instead, we cited low interest rate, currency, credit and economic data volatility combined with very low earnings estimate dispersion as good reason for low equity volatility; and we implored clients to embrace it rather than fear it. We stand by that claim and call today, but acknowledge several of these factors are likely to change in 2018.
- First, interest rate volatility is likely to increase as the Fed continues to tighten and the ECB begins its tapering process. Exhibit 16 clearly illustrates that the combined impact of global quantitative easing programs peaked in 2016. Furthermore, gross issuance of sovereign debt bottomed as populism began to force the hand of politicians to back away from fiscal austerity – our key insight last year for why equity valuations would rise rather than fall as populism took hold. What this means is that between 2016 and 2018, the net issuance of sovereign debt should increase by over $1 Trillion. This is bound to have an effect on interest rate volatility even if rates remain low in 2018.
- Second, credit volatility is also likely to increase in 2018. In fact, credit spreads have been rising lately as we are seeing more sectors struggle with their debt loads and deteriorating fundamentals – Telco, Healthcare and Retail specifically. We suspect the credit cycle may have topped in the US again with a classic double bottom in spreads after an exceptional recovery from the energy debacle in 2014-15, a view shared by our credit strategists.
- Third, economic data is also bound to see an increase in volatility from what is now an extreme reading of positive economic surprise . In fact, there has rarely been a period of such synchronous accelerating growth which was one of the key tenets of our bullish view for 2017. These periods rarely last particularly when various economies are at such different stages of recovery. This doesn't mean recession, however, it does mean higher economic data volatility which subsequently leads to higher FX volatility.
- Finally, earnings dispersion is currently at a 40 year low (Exhibit 18). We don't think it takes a complex algorithm to understand there is a much higher probability this rises rather than falls in 2018, particularly given our view on decelerating growth, rising interest rate and credit volatility, higher oil prices and tightening financial conditions generally.
So between the correlation chart and its qualitative forecasts, Morgan Stanley's conclusion is that "after a very painful slide in volatility for many traders looking for a rise the past several years, we have finally reached a point where betting on higher volatility will pay off." And while the bank had "been loath to make this call the past few years" it recommends going long vol now "as a means of protecting one's portfolio in the latter stage of this late cycle move." Who knows, one of these "go long vol" recommendations may just hit one day...