The risk of recession in the US and the rest of the developed world has grown significantly in recent weeks, so we are adopting an overweight position in safe havens and an underweight position in risk assets. This is the most significant change to our tactical asset allocation in more than two years, as we are decisively moving to bearish from bullish.
A report by an economic consulting firm provides one of the reasons for Morgan Stanley’s change, as follows:
The Economic Cycle Research Institute (ECRI), an independent research institution, warned that the US economy is on track for a recession. The ECRI has successfully called each of the last four US recessions with no false alarms.
To summarize the evidence pointing to a US recession, the ECRI US Leading Diffusion Index shows the proportion of components in all of its leading indexes that have weakened over a six-month span (see Chart 1). As the chart shows, in more than six decades this index has declined to current levels only once without a recession transpiring. Even that exception involved a near recession in 1966 and 1967, and it included a 22% price decline in the Standard & Poor’s 500 Index in 1966.
The underlying ECRI report expands upon the recession forecast as follows:
ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down – before the Arab Spring and Japanese earthquake – to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”
Last year, amid the double-dip hysteria, we definitively ruled out an imminent recession based on leading indexes that began to turn up before QE2 was announced. Today, the key is that cyclical weakness is spreading widely from economic indicator to indicator in a telltale recessionary fashion. …
It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.
Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.
So, with this dismal forecast, where does Morgan Stanley say an investor should place his money? The choices are as dismal as the ECRI forecast. Morgan Stanley ends up suggesting investments in developing markets and U.S. large capitalization stocks, as follows:
If history is any guide, a recession will pose significant challenges to equity market performance until investors start to anticipate the end of the economic downturn. …We continue to overweight EM [emerging market] equities, for which valuations remain attractive. …Within DM [developed market] equities, we favor the US over Europe and Japan where headwinds appear structural as well as cyclical. Within US equities, we continue to favor large-cap stocks. Large-cap stocks typically outperform during adverse market conditions and still have a relative valuation advantage as compared with history.
It remains hard to make a compelling valuation case for cash, short-duration fixed income and DM sovereign debt at a time when most of these yields fall short of inflation and appear expensive relative to equities and other risk assets.
Morgan Stanley actually underweights Treasuries, and overweights short-term corporate bonds. Morgan Stanley writes:
Yields are near historical lows in the perceived safe havens of the US and Germany and very elevated in markets where there is perceived risk of default. We are not compelled by either of these options.
I could have quoted more, but I suspect you get the picture. Morgan Stanley ends up complaining about practically everything. The desired investment safe havens have such miserable returns that Morgan Stanley ends up suggesting (kind-of) short-term corporate bonds, and U.S. large capitalization stocks. The best thing about this advice is that I did not have to pay for it. Unfortunatley, I do not have any better ideas, so I give a tip of my hat to Morgan Stanley. After all, misery does like company.