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Morgan Stanley: Markets May Have Fully Priced In a Recession

Mike Wilson, Chief Investment Strategist for Morgan Stanley (NYSE:MS), recently relased a note in which he argues that the recent market panic may have gotten to the point where the worst case scenario is already fully priced in. Here are the main talking points.

It's always darkest before the dawn

Wilson believes that the coronavirus and oil price declines are simply the final disruptions in an already exhausted U.S. and global economic expansion. Morgan Stanley has actually been forecasting a recession for a number of years now, basing this hypothesis on things like the yield curve, which inverted last year, as well as the performance of more defensive sectors of the stock market. They therefore believe that a recession would actually mark the end of a cyclical bear market.

Wilson also believes that the emergency monetary policies enacted by the Federal Reserve and other central banks should assuage any fears of liquidity drying up. To recap: interest rates have been cut 100 basis points down to 0%-0.25%, Fed officials have indicated that they will consider buying up other assets (potentially equities) and the Fed has injected trillions of dollars into the interbank repo market and eliminated overnight bank reserve requirements. A small amount of fiscal stimulus has already been enacted, but Congress and the White House seem to be moving towards a much bigger package.

Interestingly, Morgan Stanley seems to hold that this current crisis might stimulate an increase in spending, which they think is necessary in the context of low global growth:

"While unfortunate, a US recession with a global health crisis may be the combination that finally galvanises a shift towards more aggressive fiscal policy that we believe is necessary in a world of low growth and inflation. In fact, such policy change has always been part of our longer-term secular bull market thesis: a secular bear market, followed by a new cyclical bull, driven by new reflation.

Clearly, this will take some time to manifest itself in the real economy, which is currently engulfed in deflation. However, markets are forward-looking, and we will be looking for early signs that the transition has started. Such a change would likely have significant portfolio implications should it manifest as we expect".

Is the worst already over?

Wilson believes that investors can learn a lot from the behaviour of Treasury bond yields. Without getting too far into the technical details, lower yields denote a fear of a recession among market participants, as money piles into bonds from riskier securities. The fact that yields bottomed out even while stock prices made new lows suggests that markets may have fully priced in the coming recession - in other words, that the worst has already happened for the stock market.

The core point of the note is that we are now in a position when expectations seem to be veering overly negative, as opposed to where we were three months ago, when expectations were overly rosy. This is consistent with what some investors, including Howard Marks (Trades, Portfolio), have been saying: markets have now declined sufficiently for investors to go bargain hunting.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.