Morgan Stanley says economy is on 'recession watch' as bond market flashes warning

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The stock market and economic outlook in the United States is “deteriorating,” according to an analysis from one of Wall Street’s top investment banks.

Renewed trade tensions and a slump in economic data — ranging from falling durable goods and capital spending to a downshift in the services sector — has put U.S. profits and economic growth at risk, Morgan Stanley warned Tuesday.

“Recent data points suggest US earnings and economic risk is greater than most investors may think,” wrote Chief U.S. Equity Strategist Michael Wilson.

Specifically, the stock strategist highlighted a recent survey from financial data firm IHS Markit that showed manufacturing activity fell to a 9-year low in May. That report also revealed a “notable slowdown” in the U.S. services sector, a key area for an American economy characterized by huge job gains in health care and business services.

Many recent reports reflect April data, “which means it weakened before the re-escalation of trade tensions,” Wilson continued. “In addition, numerous leading companies may be starting to throw in the towel on the second half rebound–something we have been expecting but we believe many investors are not.”

Wilson was one of the most bearish stock strategists last year, defending his initial S&P 500 call of 2,750 for year-end 2018 without adjusting it throughout the year. By the end of the year, his call was the most accurate of any strategist tracked by CNBC.

He’s stood by his gloomy case for 2019, often warning that investors could be caught in a “rolling bear market ” for the next several years. The market has thus far outpaced Wilson’s models for 2019, with the S&P 500 up 12.9% and the Dow Jones Industrial Average up 9.7% year to date.

Still, many economists are predicting an anemic second half of the year. For their part, Morgan Stanley economists have lowered their second-quarter U.S. GDP forecast to 0.6% from 1.0%. That comes after J.P. Morgan last week cut its own second-quarter outlook to 1% from 2.25%.

“The April durable goods report was bad, particularly the details relating to capital goods orders and shipments. Coming on the heels of last week’s crummy April retail sales report, it suggests second quarter activity growth is sharply downshifting from the first quarter pace, ” the economists wrote.

Source: Morgan Stanley Cross Asset Research

Companies ranging from manufacturers like Deere and Polaris Industries to computer chip maker Microchip and toolmaker Snap-On have all bemoaned the Trump administration’s escalated trade war with China and have warned it could impact their business. The White House bumped the tariff rate on $200 billion of Chinese imports to 25% from 10% earlier this month, drawing a similar response against American goods from Beijing.

While the number of companies explicitly airing their trade grievances remains comparatively small, they likely represent a larger number of American companies set for pain as bilateral tariffs threaten their bottom lines.

“Regular readers are likely familiar with our view that the US economy is vulnerable to a more significant slowdown due to overheating last year from the fiscal stimulus,” Wilson wrote. “This led to labor cost pressures for corporations, excessive inventories and an overzealous capex cycle that is now reverting to the mean, which means well below trend spending for several quarters.”

Those market risks have been reflected in the bond market, Wilson added, pointing to an unusual phenomenon in government debt yields.

When investors believe the economy is set for healthy growth, those that buy debt from the U.S. government for years are compensated with better interest rates than those who loan money for a matter of months. Under those normal circumstances, the plot of Treasury interest rates slopes upward, with investors earning more for holding debt for 10 years rather than a few months.

That usual upward slope can change, however, when investors think economic output growth is likely to fall. That occurred earlier this year, when the yield on the benchmark 10-year Treasury yield first fell below that of the 3-month Treasury bill, a sign many on Wall Street read as a recessionary signal.

The curve flattened further Tuesday as the 3-month bill yielded 2.361% and the 10-year note yielded 2.266%.

Some investors wrote it off, saying “it’s different this time” thanks to the Federal Reserve’s lingering quantitative easing or by how quickly the curve appeared to correct to a steeper shape. But Morgan Stanley’s deeper dive into the data — controlling for the Fed’s tinkering — reveals a “much different picture.”

Morgan Stanley’s analysis shows the adjusted yield curve first inverted in November and has remained in negative territory ever since.

“The adjusted yield curve inverted last November and has remained in negative territory ever since, surpassing the minimum time required for a valid meaningful economic slowdown signal,” Wilson wrote. “It also suggests the ‘shot clock’ started 6 months ago, putting us ‘in the zone’ for a recession watch.”

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