Mike Wilson: The Fed is NOT Independent, and That's Good for Stocks

0:00Howard Marks is a legendary investor in the long term. I'll take his track record anytime, but he's not a trader. OK, and I am a bit of a trader. And what I'm telling the audience right now is that we are now into an inflationary regime. And you have to understand that that means kind of two years on and one year off. And now we're into a new two year positive cycle where inflation is accelerating again. The Fed is on hold and even cutting rates and tolerating the higher inflation. And that's a very good earning story. I don't think the Fed is independent. OK, that doesn't mean that they're not trying to do the right thing.

0:33OK, the Fed is not independent because they have a overarching responsibility to help the government fund itself. I think the Treasury and the Fed, just like in the 1940s, by the way, are working very closely together to manage the number one problem that we have, which is funding these incredible deficits. So this is this is where they're not independent. They have to intervene when the government needs their help. And I think that's going to continue. Welcome to the Master Investor Podcast with me, Wilfred Frost, where we celebrate and learn from the success of the greatest investors, business leaders and politicians in the world, giving you, our listeners, the edge.

1:16My guest today is a master of US equities and has boldly and publicly nailed his colors to the mass repeatedly since he became Morgan Stanley's chief US equity strategist in 2017, more often than not, highly accurately. He's also got the title now of chief investment officer and chair of the investment committee. He is, of course, Mike Wilson and joins me now. Mike, welcome to the Master Investor podcast. Thank you, Will. Thanks for having me on. It's a treat to connect with you. Sadly, not in person, but maybe next time. There's so much for us to get to, including obviously your current market views.

1:58But I wanted to sort of roll the clock back to start and reflect on some of the calls you've made since we've got to know each other, me in 2016, moving to the US. And obviously, you became chief equity strategist around that time. But before even doing that, how do you weigh up whether to be constructive or negative towards a certain sector or the markets as a whole. Is there a sort of set formula, a set of data points, or is there a lot of gut to it as well? Well, it's a little bit of an art and science, as you know. I would say there are definitely certain metrics that we lean on more than others.

2:33I think the difference between myself and maybe other equity strategists out there is, and I started out as a bottoms-up person and really kind of did my career backwards. So I spent a lot of time trading specifically tech stocks, TMT stocks in the late 90s and early 2000s and really began my career following individual security. So I've developed, I think, a little bit different approach than others. And I would say the main item that I focus on is essentially the rate of change, second derivative on growth for either earnings and earnings revision breadth or just in terms of expectations. And that's how stocks trade.

3:16That's how we've learned over time. But the highest efficacy metric that we follow is earnings revision breadth. It's a coincident indicator, but if you catch the turns correctly, it really is quite valuable. And it works at the index level, works at the stock level, works at the sector level, and it works on a relative basis. And I would say that we've used that probably the most effectively. We also, of course, follow policy and policy changes, particularly in the last 20 years. In fact, I've been wrong a lot of times because I've ignored policy or not ignored it, but just haven't put it in the hopper in a big enough waiting.

3:51And I think in the last 20 years, policy changes and rate of change on the policy has become a much bigger determinant of equity prices, in particular, risk assets more broadly. So those are the two big ones. And of course, interest rates fall into that category, it's not just monetary policy, it's fiscal policy. So it's really the rate of change on earnings growth and not so much GDP growth, but earnings growth and also interest rate and policies. And Mike, has that key factor, the rate of change on growth and policies, you say, become less strong of an indicator of change in direction over the time?

4:30Or is it still as strong as ever? Just perhaps you have to look more at the long term and short term disconnects can exist for longer. Well, what we've discovered in the last 10 years also is that we have this passive strategy flow dynamic. Let me kind of go into that for a minute, which is, you know, 25 years ago, the marginal price setter of security was generally a pretty well informed institutional investor. maybe as a long-only, uh, outset allocator type, who's really trading the fundamentals of a company's business. Um, and now in the last 20 years, it's become, you know, the marginal price setters become either retail passive flows, uh, CTAs and other institutional passive flows that target, you know, vol or they target, uh, you know, uh, price momentum, et cetera.

5:21And so the fundamental portion of the price discovery has become less important. And that's an area where, quite frankly, I feel somewhat, we're probably one of the better positioned people in the world to determine kind of where the flows are. And there's sort of the institutional passive, there's the fundamental institutional, and then of course, there's the the retail flows. But even with our breadth of, you know, eyes and ears out there as Morgan Stanley, I mean, it's very challenging to kind of predict those flows. But that has become a galvanizing factor, a really an important determinant of prices.

5:59And quite frankly, something I hate, because it's nothing you can analyze in a proactive way. It's more reactive. Yeah, that's really, really interesting. Those changing shifts of, I guess, where the where the marginal bit of AUM is over the last decade or so. As I mentioned there, we got to know each other from 2016 onwards. You became chief equity strategist 2017. You were correctly bullish then for a few years when people were kind of struggling for direction. But the part I want to review initially is a moment when you absolutely nailed it. I remember covering it closely and you really stood out.

6:34You were correctly bullish coming out of the pandemic. You called the low in March 2020 and then turned correctly bearish in late 2021. Of course, 2022 was a big negative drawdown year. What did you see in those two moments that led to those calls? And I think it's fair to say really kind of elevated you as the top equity market strategist at the time. Yeah, I mean, I would say in the pandemic, we came into 2020 with a bit of a skeptical view that we were setting up for some sort of a recession, quite frankly. And you never know what the trigger is going to be. But of course, when the pandemic hit, and then it was really the lockdowns that caused the economy to freeze up.

7:22And when we saw that in the moment, and we looked at all of our indicators, particularly the valuation indicators, equity risk premium, we were like, okay, well, this is it. This is what we've been kind of waiting for. and so we were able to kind of jump in there on an evaluation basis but also knowing how the policymakers would respond so it was it was kind of coming in with a bit of a you know skeptical eye and then when the event hit we were in position to flip it and I think you know we've been around the block and enough times I think we kept our head on our shoulders probably more than most in that moment and then and then and then of course the Fed and the government came in with incredible amounts of stimulus.

8:02And we identified that correctly at the time as quote unquote helicopter money. And we even predicted that there would be inflation ultimately from that, but that in the short term, it would be very bullish. So the reason we were able to flip negative then at the end of 21 is we started to see the Federal Reserve, particularly Jay Powell, start to talk more bearishly or hawkishly about policy that he was going to have to deal with inflation. And I think people were still trying to catch up with performance at the time. So we were able to get in front of that. We called it fire and ice at the time, right?

8:33There was the fire of the inflation, which is very bullish for growth, but that leads to ultimately ice because the Federal Reserve has to respond. So we did nail that, but of course, we've made some bad calls and we'll probably get to that in a minute, not getting everything correct. But that was, I think, that was a result of our experience having the right framework around understanding how policy would respond to the shock of the emergency of the COVID event. And quite frankly, it was also something we're waiting for from a long-term perspective. And we were coming off a period of long-term secular stagnation, not having enough inflation.

9:09And so we needed inflation. And that was very, very bullish for stocks for a period of time. But of course, there was a governing factor when inflation gets out of control. Obviously, then the Fed did hike rates. You're absolutely correct that that led to a down year in 2022. And you did call the October low, again, remarkably. But I think it's fair to say, Mike, at that point, you kind of called it as a trading low. and then even though you kind of pointed it out at the time, we're a bit ahead of the curve, you didn't drastically change your positioning and remained largely kind of negative to US equities bearish for the following year or so, even when stocks bounce.

9:53So did you miss something then into 2023 and early 2024? And was that punishing for you? Was that tough? Oh, absolutely. I mean, let me just go through it. I mean, we basically, we got the trading low on 22 for the same reason we kind of got the trading low in 2020. I mean, a lot of our metrics were saying, you know, the same thing. We were very oversold stocks. The average stock was very, very cheap. What we missed was that the liquidity picture was actually changing beneath, you know, beneath the surface. And we were, I would say, it just didn't have the right tools in place to see that change in liquidity, but that's what happened.

10:27And then, of course, in the spring of 2023, we got the regional bank crisis. And so we saw that and didn't predict it, but we saw that and said, okay, well, this is going to be now the final low. And so we were basically saying at the time that we're going to make a new low close to$3 ,000. We got to$3 ,600, and we just overstayed our welcome, quite frankly. But what we missed again was the fact that the Fed came in and provided an incredible amount of liquidity with the BTFP to help secure the regional banking system. And then the other thing, of course, that came along was AI. and chat GPT was launched in the fall of 2022.

11:05And we just underestimated how voracious the appetite would be for this new theme in addition to the liquidity that was being provided. So as you recall in 2023, I mean, that was really the, I mean, talk about narrowness of the market. It was truly seven or 10 stocks. And we just missed, I missed it in terms of the, I just couldn't get ahead and say, oh my God, this is going to be, you know, this is just a real theme that people are going to get excited about. So, you know, 2023 was not a good year, despite the fact that the average stock performed really poorly in 2023. And our earnings revision breadth indicator, by the way, was terrible during 2023, except for those seven stocks.

11:46So it was, you know, we just got it wrong. And then of course, 24, we stuck around too bearish as well in the first half of 24 on the same idea. And yeah, we learned a lot during that period. Quite frankly, I think it helped us a lot this year, understanding the dynamics of both AI and the liquidity picture. And you flipped bullish in June 2024. You've been largely bullish and constructive since then, but also with a trading caution at the start of this year. So the last 12 to 16 months have been right on again. Just quickly, because I want to go into today in more detail in the second half of the conversation, but quickly, what flipped you in the summer of 2024 to be constructive?

12:37Well, we did start to see revision breadth start to pick up for the broader market a bit. Finally, the economy was doing a little bit better and stocks were doing a little bit better. And price, basically, the technical picture looked a lot better. That's one thing I didn't mention at the beginning. I used technicals quite a bit. And so that breadth improvement, in addition with higher prices, was just like, OK, well, obviously, we're, you know, we got to get more constructive here. And then correct. I mean, we we've we coming into this year, I think our key insight was that Trump, too, would be different than Trump, one, because in Trump, one, we we identified correctly that, you know, he was in a reflationary president.

13:15then he was going to do all the pro-growth stuff first and his growth negative stuff second. And this time around, it had to be the opposite because inflation was still right beneath the surface. And so I think sequencing a policy was why we came in more negative this year, which allowed us to be very well positioned again to kind of call that low in April.

13:36Before we get onto the picture today, Mike, I'm interested if maybe it falls into the period we just covered. But obviously, you've had a long career before that as well. Is there a moment which led to a significant change in that process that you outlined for us at the top of the interview? Is there a moment you look back on where you thought, do you know what, before that, I never used to consider this a factor. And now it's a really important factor for me when I weigh up my views. No, I think it's just evolved over time. I mean, if you think about what I used to look at 25, 30 years ago, it was very micro and it was very company specific.

14:12And it was their traditional metrics of, you know, just looking at kind of, okay, well, let's just do a model and try to predict earnings here. What's the valuation look like? And so now there's just, you know, it's become a mosaic of different items. I mean, the biggest one, of course, as I mentioned, is policy. And a lot of that is these unique policies from monetary authorities in particular. We're now in an era of fiscal dominance, something that we were probably early to identify in April of 2020 and some of the dynamics there. And of course, these passive flows. So it's not one thing in particular, but you always have to adjust your process to the environment.

14:46I mean, I don't think markets have ever been static over long periods of time. I think that best investors in the world who I have a privilege of talking to always adjust their process because, and I would say the gout and probably the factor that forces people to do that the most, quite frankly, is price and performance. If you're wrong, by definition, you're losing money or you're not making as much money as you should be. You're not capturing. You have to decide, okay, am I going to stick with this longstanding process that has worked for 30 years or am I going to try to make money here? I mean, the only person in the world I think who's probably stayed true to their process is Warren Buffett.

15:25I mean, the guy is one of the greatest investors of all time. And he's also, I think, literally probably done the same thing for 60 years. But he has this one major advantage that most people don't, which is time. He doesn't care about underperforming for years. If he thinks he has a view on something, and let's be honest, most asset managers can't do that. Most even asset allocators can't do that because you get fired or if you perform for so long. But individual investors do have that luxury, but they probably don't have the skill or the wherewithal or even the process in place to stay with it.

16:05But that is the one advantage that the audience should understand. As an individual investor, as an asset allocator, the main advantage you have is time. You don't have to do anything. If you're willing to stand there and say, I'm just going to wait for the market to come to me, give me good value in certain areas, or I'm going to do something that's out of consensus because I have a very strong fundamental view about the next five years. And I still do that, quite frankly, in my own investing, where I have a view on something three to five years out, I may start to acquire a position in something and just say, I'm not worried about making money today.

16:36This is a view I have. And I think a lot of great investors do that. And your position as a sell side strategist at one of the biggest banks, you get mark to market, I guess, more often than most. So the pressure must be significant. Let's talk about the picture today. And clearly, as we've already outlined, aside from that early part of the year where you were cautious, you've been constructive now for over a year. I think I'm right in saying you still are. On the headline numbers on the economy in the US, do you think there'll be a recession in the next 12 to 18 months or not? Well, this is probably where we have a very differentiated view.

17:17We've been talking about this for quite a while, part of the reason we stayed bearish too long in 23 and 24 is that we, we actually believe we were in a recession in those years for the private economy, for much of the private economy, not all of it. And let me kind of go through that framework, which is, you know, coming out of the pandemic we had this incredible stimulus, you know, we call it helicopter money. And, you know, that really affected certain parts of the economies, you know, technology stocks, you know, to work from home had, had a boom in spending. We had consumer goods companies, you know, do really well because people are at home buying things for their house or for their, you know, whatever they're doing at home.

17:56And so that was the worst part of the economy in 22. There was that payback from that boom in 21. And then since then, literally when the Fed raised rates, I would say 70 % of the US economy is going through what I call a rolling recession at different periods of time. And those higher interest rates have remained too high, in my view, for many parts of the economy that are levered to interest rates, housing, some of the durable goods areas, autos, commodity sectors, manufacturing has been in the dull terms for three years. So what we think happened earlier this year is we ended up having a recession in the areas of the economy that had been kind of holding things up.

18:40Let me go through those. AI, CapEx, government, and then consumer services. All three of those sectors had a recession in the first quarter, really started in the fall of 2024 with AI. AI CapEx started to decelerate in the fall of 2024. And that deceleration bottomed in April when we saw a lot of the rate of change again on CapEx bottom out in that April period. The other thing we had was the government had a recession in the first quarter because of Doge. And there was a massive layoff cycle that actually played through the numbers. And then, of course, consumer good or consumer services, rather, has seen a major slowing, whether it's travel, restaurants, et cetera.

19:21So that completed the recession. And we've laid this out in our research in detail. We think the rate of change, once again, the rate of change on the jobs market bottomed in April. And that coincided with earnings revision breadth, which is also now seeing a V-shaped recovery. So we think it's pretty clear that we had the recession. Everybody missed it effectively, including the Fed, because it was a very unusual recession. Typically, when you get a recession, everything kind of goes down at once. This time around, it took two or three years with each sector of the economy kind of going through it at different points in time and a final kind of crescendo in April, which shows very clearly, once again, the bottoming, the rate of change bottom for earnings revision breadth and for labor market indicators that we think are important, for example, payroll revisions and challenger job cuts to be more specific.

20:16I want to come to what that means for the shape of the economy in just a second, but a tangent because you mentioned the rate of change of AI CapEx in the fall last year. What is that looking like now, the rate of change on it? I mean, the announcements are significant. Are they starting to slow the scale of the incremental AI CapEx? Or if that does start to slow, what would that lead you to conclude? So the AI, I mean, first of all, the US economy has been very deficient in capital spending. Okay, we've over consumed and we've under invested now for the better part of 20 years, in my opinion.

20:55And I don't think most people would disagree with that. We pull forward demand post the GFC with negative real interest rates and quantitative easing and other programs to stimulate demand. But we've been underinvesting, which makes sense. When you have negative interest rates, companies have a disincentive to invest in real capital projects with real risk. Instead, they do financial engineering. But now, because of this, you know, with the tariffs, which is essentially a consumption tax, and then using those tariffs to incent businesses to do more spending in capital through the big, beautiful bill, What I expect now is that not only are we going to see AI CapEx do well, but other forms of capital spending across the U.S.

21:39economy. And this is by design. I think the administration is trying to incent businesses to use their balance sheets to invest because that ultimately will lead to higher growth. And this is part of the story that the stock market has figured out, that this higher capital spending across the economy will lead to better growth over time. probably inflationary too at some point. And we can get to that in a minute. And it's positive in the short term and probably there'll be a negative impact of that later on. But generally speaking, I've taken this view that the rebalancing of the economy now is happening on three planes.

22:13Number one, more exports, less imports via tariffs and weaker currency, more investment, less consumption via the big, beautiful bill and also the tariffs restricting consumption. And then rebalancing the economy from what I call the high end to the lower middle class income consumers via immigration restriction, which should help real wage growth at the low end. And of course, AI will suppress wage growth at the high end. And it is kind of an interesting, when you think about it that way, the policies do make a lot of sense. And I think the stock market, quite frankly, has figured this out. As we like to say, trust your own analysis and your framework, but then verify it through the stock market or asset prices.

23:01And I think the asset price movement we've seen this year has verified our analysis. And I think that thesis or that narrative I just laid out is one explanation for why the markets are doing what they're doing. So I'm really interested in what that means for the stock market going forward, because I guess what you're saying is this two-speed economy that we've had for a year or longer, AI taking off and housing stocks, for example, the regular economy stock struggling. Do you expect that to flip over the next couple of years, both in the economy and perhaps more importantly for our listeners in the stock market?

23:38We do think it's going to be the story for 2026, meaning we should see a broadening out, which is, by the way, what's what the earnings revision breadth is telling us. Let me give you another statistic. The Russell 3000, which is large caps and small caps, it's probably the biggest index that we have. The median stock, okay, so it's not the average, but the median stock has been in a very deep, long earnings recession for the last three years, negative earnings growth for three years running. And that just flipped positive in the second quarter. And in fact, now in the third quarter so far, the median stock is showing 11 % earnings growth year over year.

24:15That's the fastest earnings growth we've seen since the fourth quarter of 2021. All right. So that is a clear indication that we are seeing the overall economy starting to heal from that rolling recession bottom that I just sort of discussed, which means that we should see the market start to broaden out on 24 and areas that have really underperformed, areas like transportation stocks, some of the regional banks, perhaps consumer goods, as we see volumes pick up again, commodity related sectors. By the way, it doesn't mean that the winners have to completely roll over. It just means we're going to see more companies do better.

24:55And so their stocks should do better as well. I mean, we do have a K economy in the in the market as much as we do in, say, the consumer sectors, right? I mean, so while the high-end consumer is doing well, low middle class not doing as well, it's the same thing in the corporate world, right? The top 10 % companies are doing really well as they have scale and they can deal with this kind of weird economy. And now we think that's also changing where we could see it broadening out into 2026. The thing that's been holding us back is the Federal Reserve, because I think the Federal Reserve does not have the narrative I have.

25:28I could be right. I could be wrong. I think I'm right. And the Fed will ultimately figure this out, that the labor market has been a lot weaker than they thought, which means that interest rates can come down more than what the market is projecting. And once that happens, that broadening out will really happen in earnest. I think you said that it would broaden out in 2024. I think you meant 2026. The kind of pushback to that Howard Marks offered us a few weeks ago, and And I refer people back to that episode. But he said he wasn't concerned about the valuation of the MAG-7 because they're uniquely brilliant companies with very strong moats, et cetera, et cetera.