Mike Wilson- American Prosperity Threatened? Yes, but...

Our conversation with Mike Wilson of Morgan Stanley on April 6, 2023 covered many big picture topics as well as some near term market predictions. Below is a summary of our conversation by the topics we discussed.

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US Prosperity today
Mike chose to emphasize non-financial components of “prosperity.” He is optimistic given how the US has adjusted and survived so many difficult periods in the past, but today there are many serious challenges that have not been as noteworthy in past cycles. The general condition of societal satisfaction is actually low relative to history, especially the last 80-90 year cycle. He said that views about the societal value of family structure, religion, education are waning in the younger generations very rapidly. It is troubling and perhaps threatening that discourse is not addressing the stress in the system between those who want to hold onto the past and those who do not. This was the case in the 1940s as well. Freedom of speech is the swing factor to monitor. But Mike remains an optimist as our system has faced threats in the past and has withstood them. But there are financial dynamics that point to a less dominant US position in the global financial system and power structure.

Mike’s Predictions
1) Shorter economic cycles
2) Structurally higher interest rates, and no return to the Zero Interest Rate Policy
3) Higher cost of capital results in more differentiation- better capital allocation, losers fail
4) Narrower dispersion of income for individuals and companies. Better opportunity for talented operators and investors.
5) Multi-polar world and pressure on the US
a. The dollar? Growing risks that foreign government lenders will scale back- harder for the US to finance itself
b. Losing currency reserve status is possible over time
6) Higher taxes, Federal budget cutbacks
7) Higher investments into economic infrastructure
8) Higher labor productivity from tech used in Health Care, Energy, Education, Industrials and even service industries
9) The S&P500 is at risk from both earnings and multiple and sees downside to 3000-3500 in the near term- though this depends on his earnings forecast more than anything- if that is wrong, then there is a chance we saw the bear market lows already.
10) He expects rates to be about 200 basis points below inflation for 10-15 years

Promising new technologies AI & Blockchain
Both hold promise to avoid failing as most new developments do, but they are both so young, it’s unclear that they will become transforming technologies for the economy. The big potential for blockchain lies more in its use for improving efficiency than in its use as crypto-currencies.

Recession chances
Morgan Stanley economists say recession odds are 50%and he sees particular weakness coming from financial, industrial, and some technology sectors. He thinks S&P500 earnings will be about $180 vs $220 consensus.

Labor Productivity
This is perhaps the most significant factor in economic growth, especially for the tech heavy US economy. Tech in the 1990s led to significant white collar labor productivity gains, but tech since then has not led to productivity gains- its been used by a small number of companies that became in boosting consumer services, eg entertainment, shopping convenience, transportation and food delivery.

Banking sector
Today’s environment is challenging for the US banking sector as zero-rate deposits will either be lost or repriced higher. Balance sheets are impaired until rates come back down, but higher rates are not as likely as lower rates at this point. Cost structures will be pressured with additional regulations as well. And finally, they will be left less competitive versus the large and growing shadow banking system. Credit will therefore be constrained going forward, as was the intention of the Fed in this tightening cycle. Commercial Real Estate is a risk, but likely a manageable one that will be redeveloped over time and the losses will be manageable system-wide. Remember that bank lost revenue from paying higher rates for deposits winds up being a benefit for consumers.

Bear Market
Bear markets do not typically end with the market characteristics we are seeing now. Chief among these is the equity risk premium (ERP), which is actually lower today than before the decline began and therefore is not reflecting any risk to growth. It is more likely that we get downward revisions to earnings in the near future that will cause the ERP to rise; equity prices in the US would then decline on a lower multiple and lower earnings. This would lead to a Fed easing cycle and an end to the bear market. Ironically, if earnings do not decline, and we do not get the recession, then the Fed will not shift to easing, and that will prevent any bull market from returning.