Morgan Stanley explains why a continuation of the Fed-led risk rally is anything but guaranteed

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  • Investor risk appetite has improved noticeably in early 2019, mirroring what was seen 12 months earlier. Obviously, the backdrop on this occasion is very different.
  • Morgan Stanley says the recovery in risk appetite is largely due to a dovish shift from the US Federal Reserve.
  • It says a continuation of the Fed-led bounce is anything but guaranteed, pointing out that FOMC members face a “challenging combination”.
  • The bank says it’s still “too early to position for a larger, more sustained rally in equities or credit”.

Mirroring what was seen a year ago, investors have been in a cheery mood in early 2019. Stocks have rallied, volatility has reduced, cyclical currencies have risen as have many commodities, and corporate credit spreads have fallen.

While the backdrop from where these moves have stemmed from is very different to that seen a year ago, fueled on this occasion by cheaper valuations and the prospect of easier or steady monetary policy settings as opposed to a continuation of the synchronised global cyclical economic recovery in early 2018, it’s clear many investors are now betting that brighter times lie ahead.

Andrew Sheets, Chief Cross-Asset Strategist at Morgan Stanley, says the major reason behind the recovery in sentiment is the dovish shift communicated by the US Federal Reserve.

“If valuation and sentiment were the tinder for the rebound, the Fed was the match,” he says.

“After nearly going out of its way in December to suggest policy should stay the course, the Fed’s tone has softened notably to start the year.

“Equity and credit markets cheered, recouping all their losses since mid-December. But rates markets yawned. On December 31, rates were pricing no Fed hikes over the next two years. Today,… expectations are almost exactly the same.”

The Fed, in Sheets’ view, helped to spark the risk rally seen in recent weeks. The key question now is whether the recovery in risk appetite will continue.

Sheets says the combination of markets pricing in the next move in the Fed funds rate as being lower, at a time when US economic growth is still likely to be pretty decent, will mean the Fed-led risk rally could easily come unstuck.

“It’s a challenging combination,” he says.

“First, while US growth is slowing, we think it remains above potential. Q4 US GDP likely finished around 3.6%, December payrolls were over 300,000, core CPI is 2.2% and the better tone is once again easing financial conditions. The Fed can certainly change its hiking path, but this might create some near-term discomfort.

“Second, with the markets priced for no hikes in 2019 and cuts in 2020, any Fed action will amount to a surprise.

“And third, so far the more dovish message has been more vague on balance sheet policy, a notable omission.”

So will the Fed — currently anticipating two 25 basis point increases in the funds rate this year and another in 2020 — be able to manage investor expectations sufficiently to ensure a repeat risk rout similar to that seen in late 2018 doesn’t eventuate this year?

It’s a tricky situation, even if upcoming US economic data allows room for the Fed to pause its tightening cycle for a significant period of time.

“The data could weaken faster than we expect in Q1, giving the Fed more leeway, but this carries its own very obvious problems,” he says.

“We think investors are often too quick to forget that, prior to 2010, weaker data and easier policy were a poor backdrop for risk rather than a supportive one.”

While Sheets believes many of the assets that were beaten up the most in 2018 are likely to outperform this year, he cautions it’s still far too early to declare the market rout as being over.

“We think it’s too early to position for a larger, more sustained rally in equities or credit, especially as many markets have already bounced quite meaningfully over the last three weeks,” he says.

“A more meaningful change from the Fed on its balance sheet, or China on its fiscal impulse, would lead us to revisit this view.

“2019 is off to a good start, and that’s certainly welcome, but there’s still a lot of year left. 2018 started with a pretty cheerful tone too.”

Indeed it did, and look how it panned out.

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