The Market Is Entering a New Cycle - Morgan Stanley's Mike Wilson

Thanks, man. Great to see you.

We kind of invented that term because we were trying to figure out how to explain what was going on post the pandemic. And because of the nature of the pandemic, the shutdowns and the V-shaped recovery and all of that and the dislocations, it was just an abnormal recovery from 2020. And you know what we noticed? We were in really a broad earnings recession starting in 2022 with the big tech stocks. Quite frankly, there's a lot of payback for demand there. And then we saw essentially most of the private economy going through a recession of some sort at different times. So, normally when you get a traditional recession, everything kind of just collapses at once because there's some shock that just tips you over and like every industry is firing people at the same time and, you know, they're all having negative comps and everything else. And this time around, what we saw was sort of this staggered sort of recession through the economy. And having said that, I mean, the majority of the private industries kind of were in a three-year recession. And you know that explains things like the PMIs being below 50 for three and a half years straight, right? So manufacturing was just in this elongated recession. Consumer discretionary stocks, same idea. You look at a lot of the commodity sectors and you look at many parts of the small midcap parts of the complex. That's why we had such narrowness in the Mag 7 that was really kind of covering up this malaise. And I still think it's a novel idea, but we've shown the data. We've done the analysis on this, but that you were sort of calling for this going into 2025, a year ago, that what we needed to finish the recession was to have a recession in government. Like that was the one sector that had kind of avoided a recession post the pandemic because there was so much stimulus. And so that makes sense. And then we got it and that was basically Doge. So, as unsatisfactory perhaps as Doge might have seemed at the time, it actually did eliminate about 300,000 government jobs, which is a pretty healthy reduction in government employees, about 10%. So, that's a severe recession. And that's really what bottomed everything in April, under the guise of tariffs and Liberation Day. That was sort of the final blow to the markets. But basically, we priced in that recession in April of 2025. S&P down 20%, many stocks down 30, 40, 50%. And we talked about that at the time. And then we had the reflexive move higher. Now, it wasn't as dramatic as the reflexive move of course in 2020 because the decline itself wasn't as bad. So, we're in now what I call a rolling recovery where not every sector is participating as much. It's not collective, right? It's happening kind of piecemeal. And that was really playing through nicely up until about I'd say two months ago. And then we started to have other things start to weigh on the markets. I would say most notably AI now kind of eating itself. The AI disruption on labor in various parts of the market and those stocks have been punished for that concern whether it be software stocks or business services companies, things that could be disintermediated by AI effectively. So that's one thing that's kind of been weighing on stocks. And then the second one of course has been this private credit malaise which I think there are real issues there. I don't think it's a systemic problem yet or today, but it's a problem for private credit managers for sure and it's a problem for things levered to that and that's another outgrowth of some of the software problems as you know. Now we have the Iran conflict and the war and that's to me very similar to last year where we had a lot of things weighing on the market going into Liberation Day and the Liberation Day was the final blow that caused a recession. Now, the difference between this year and last year is that I don't think we have to have a recession this time because the underlying strength in the economy is much better going into this war. And I don't have any great insight around what's going to cause it to end. But I think the markets have a way of pricing this stuff pretty quickly. And it's no coincidence that oil and energy stocks were the best performers well before we attacked. It's not like it was a total surprise to the markets even though it's still a terrible event that nobody really wants to see. And so now the markets are in the process of kind of finalizing that. And so I don't think unless oil is going to stay above, call it $120 a barrel globally. That doesn't mean just Brent, but also remember WTI, somewhat insulated from this because of the excess production in the US. So the spread now is widening out between Brent and WTI. The US is pretty resilient to this at least for a period of time. There's also the tax refunds which are running up about 17% year-over-year which is a nice buffer against higher gas prices for a period of time. And of course, we have a lot of capex now picking up because of the incentives in the big beautiful bill. So there's a lot of underlying strength in that rolling recovery that I think will prevent a hard landing, i.e. recession unless this really gets out of hand. And I'm not in the business predicting tail risk. I don't think anybody knows what's really going to happen with this conflict and price of oil. I also believe that global economies will solve this problem because it has to, right? Because the alternative is a global depression. So Iran's going to get a lot of heat from a lot of people besides Israel and the United States if all of a sudden we wake up in June and oil is still 125, 130 and a lot of economies are bleeding out. So I think this will resolve itself over the next couple of months.

Yeah. So, I mean, our general view was it was a continuation of our call in May of 2025, but we got a little more aggressive with some of the positioning. We've been very patient waiting to upgrade small caps and equal weight because we're kind of waiting for the Fed to get around on a few things and so we waited till November. And since November, that broadening out has been the story up until recently of course until the Iranian war and oil price spike. So I think that's a temporary interruption or interlude in our core view. I want to make that clear like I don't think that these trades are going to work perfectly for the next month or so as we go through this but ultimately they should resolve higher and those areas would be kind of an equal weighted S&P over market cap weighted, small midcap space, consumer discretionary area where they've been coming out of a recession, the manufacturing sectors, industrials, some of the financials that have been left behind like the regional banks for example as opposed to just the money centers and the alt managers which have really been suffering and then commodities, the metals. We were really much more bullish on the metals and some of the materials than we were on energy to be honest. So, we didn't call the energy rally this year, but we're happy that sort of participated. I still think the better trade now because I think you want to kind of fade energy a little bit and go back to some of the materials and metals ultimately.

There's also choices within the indices so like the Russell 2000 is the one everybody quotes but it's as you know one of the lowest quality indices in the world so we've been focused more on the S&P 600 as an example of maybe something you might want to think about as opposed to just going for the full beta Russell 2000. The Russell 2000 has outperformed as well, but it comes with a higher risk, particularly in an environment that we're in now. So, I would say from an index standpoint, I still favor S&P 600 as opposed to the Russell 2000. And then, of course, within the index itself, there's always idiosyncratic opportunities to be better than others. Once again, I'll highlight consumer discretionary. I think is an area where there's a lot of small cap businesses that are going to get a bit of a lift here from some of the policy changes, some of the deregulation, some of the pent-up demand that's been out there. And I do think rates are probably going to be cut ultimately by the Fed once the inflation concerns kind of go by the wayside. So there are definitely areas within the small cap space that I think will outperform.

Yeah. I mean, well, first of all, let's just talk about valuation. The valuation in the late 90s was much more extreme. I'll give you two things to think about. One is equity risk premium. So, today the equity risk premium is close to zero. It's a little bit positive. And some people would say, 'Well, that seems awfully rich, Mike, that stocks are the same price as a 10-year bond.' But think about it in this context, Meb, and you're a scholar of market history. I mean, I believe that the single biggest impact of COVID is that we're now into an inflationary regime that will probably last 30 years, okay? That's just the way interest rate cycles go. And if you believe that, then your number one concern as an investor is you got to beat inflation first. And that's why I mean fixed income has been horrible really since COVID, really since 2021 when the Fed started raising rates and I think fixed income is going to continue to be pretty lackluster because you're fighting that inflationary dynamic and that's the disadvantage of fixed income. It doesn't protect you against that inflation risk. What does well? Stocks, high quality stocks and that's why the S&P has done so well, NASDAQ 100 done so well because people have said look I understand this inflationary risk but I want to own the best highest quality companies because I know that they can kind of outgrow inflation over time and that's one of the reasons why small midcaps have underperformed. However there are periods of time where the low quality names actually outperform the high quality names because that inflationary impulse comes back in a positive way meaning it drives earnings growth, which is what we're seeing in that chart you just showed, right? We're seeing inflation in business, pricing come through because demand now is actually exceeding supply in some of these businesses and they're able to capture that. It won't last forever. We're not making a call on small caps. They're going to outperform for 10 years. This is like a 12-month, maybe 24-month sort of trade. But that's our job. Our job is to say this is a period in this inflationary regime where you want to own that beta because we think if the Fed's on hold and you're getting that pricing power through, then you can outperform. So this period is nothing like we've seen in our investment time frame and I'm older than you, but what it does look like a lot to me historically speaking. We worried about this five or six years ago. It looks like the 40s. It looks just like coming out of World War II where we had the same dynamic. We had all this excess debt from the war. You could argue we've got excess debt this time from probably three wars, whether it's Afghanistan, Iraq, and now potentially Iran and obviously a war on the virus. I mean that caused a bunch of debt to build up too. So we've had the same setup now where there's only one option which is to inflate your way or grow your way out of the problem. And ideally you do it through both higher real GDP and inflation and that's what happened in the 40s. Now you had a little bit tailwind there with demographics and rebuilding the world because of all the destruction that had occurred. Okay. So we have a different view about how that higher nominal GDP growth can happen. But that's a totally different environment than what we've seen in the last 30 years where you've been in a disinflationary environment, right? In the 90s it was a lot of productivity, a lot of real growth. In the 2000s it was kind of financial repression, a little bit of gimmickry. They had a commodity cycle in there at one point. But the thing that was always in place was that the Fed could always come in and bail everybody out when you don't have inflation. Now with inflation just below the surface, the Fed has to be a bit more two-way. And that means it's going to be an environment where you have to kind of trade it back and forth. I'll just sum it up. What this looks like in the 40s and 50s was you had these hotter but shorter economic cycles. Okay, instead of these elongated 8 to 10 year economic expansions where the Fed could keep them going forever, these sort of two-year or three-year up cycles, a down cycle lasts a year and then the same thing another two-year upcycle, three-year upcycle. And that's what we've seen since 2020 quite frankly. So, it's just a different way of investing. You know, it doesn't mean you can't buy and hold good companies. What it means though is you got to be a little bit more aware that you could have a 2022 again and you might want to step out of the way a little bit when the Fed has to tighten probably more than you think.

I mean like the Fed is kind of a victim of their own whatever policies, right? And they've kind of trapped themselves over time. And so now they're always kind of chasing backward-looking data to some degree. I did a podcast earlier this week. I do a weekly podcast and I am looking for some sort of final capitulation here in the next three or four weeks. And I did think that the Fed might be a little bit more hawkish today only because of the war. I mean, it's uncertain. They don't know and they don't want to be guiding to too many more cuts or anything anytime soon with that as a backdrop. So, they're leaning towards their inflation mandate away from their growth mandate even though both are kind of in a bad spot right now. And so, I think the market did interpret this as a little bit more hawkish and that's why we sold off today. Now, good. Let's go back to the framework that I've been using. The Fed, I believe, is not independent. Okay, not that they're captured by the White House, but they're not independent of their obligation to help the Treasury fund the government. Okay, I've been saying this for whatever 5, 10 years. I mean, they will talk about their number one, number two mandate of full employment and price stability so long as financial conditions, the third mandate is okay. But as soon as the third mandate is not just the stock market going down, it's really that the treasury market gets disrupted and they can't do treasury auctions in a smooth way and you get bond volatility spiking. So if you notice over the last three or four years, every time bond volatility spikes the Fed rushes in whether it was SVB and the regional banking crisis or it was just a failed bond auction in say the fall of 2023 or 24. So to me the market understands this. Okay, the market knows we have to inflate our way out. The market knows the Fed's going to have to play ball. Paul Volcker doesn't live anymore. Okay, they can't just fight inflation. They have to keep the thing kind of going a bit. And this is the key observation, which is why stocks may not be as expensive as you think. Right now, gold has gone obviously through the roof. And if you look at the S&P 500 divided by the price of gold today, it's still 70% below where it was in 2000. Think about that. So we basically are going nowhere. We own stocks and some stocks by the way have outperformed and so that's your protection, right? And I think individual investors, retail investors, asset allocators, they understand this dynamic. You know, people are not dumb and particularly retail investors. I hate when people make fun of retail investors because they're not stupid. It's their money. They get the joke. They're like, 'Wait a minute. I got to protect myself. I got to own something that's going to do better than gold or at least keep up with gold.' Okay? And the debasing that's been going on now for 20 years. This is not a new phenomena. So now if you think about it, everything is cheap relative to gold in theory, right? Oil is the biggest ratio we've seen ever, like 80-fold, or real estate is cheap to gold. I mean, and I've been a very much a gold bull, but you have to ask yourself, is gold maybe the one that's kind of overvalued now a little bit? And maybe stocks are the better hedge against inflation from here, at least for a period of time. It's a longer answer than you're probably listening or you're looking for to your question which is the Fed is captured by Treasury. Okay. Treasury is captured by Congress. Okay. And the fiscal dominant theme is very much in place because if we don't kind of push the boat this way harder still then we have a deflationary environment. You get Japan. Okay. They've been trying to fight this for as you know for 15, 20 years. They finally got probably a little more success than they wanted in that regard and it's just a hard thing to kind of balance.

Well I mean this goes back to probably 2014 quite frankly where we started to question the 60/40 as not just gold but alternative investments. So whether that we're talking about private credit, private equity, gold, and other hard assets as part of a bigger bucket. And when I did this call or podcast in September of last year, I was incrementally more bullish on gold at the time and it came out as all that 20% should go into. Somebody asked a question, all that should go into gold, right? And I said because you sound like you're really bullish on gold. I said, well, there are times when it's going to be a bigger part of the portfolio if it's performing. And that's exactly what's kind of happened. So, I, as I said in the interview, I said, look, if you have no gold today, 40%, I would not advocate doing this swap all at once, right? This is a thing where, you know, you should have had money moved away from fixed income over the last 10 years, quite frankly, as rates were going to zero. I don't think that's a brilliant statement, okay, to diversify away from fixed income when your nominal rate was negative in some cases, which is just crazy. But now that's normalized a bit, right? So like real rates on 10-year Treasury yields or even other sovereign debt is close to 2%. If you believe break evens, right? I mean, that's questionable, but at least it's a positive real yield. You know, you're not getting nothing. So I think fixed income still plays an important role because you get income, okay, as long as you're getting a real rate of return that you can feel comfortable with. So I wouldn't, I would probably shorten the duration a bit. Meaning gold can play the defensive asset, which is what duration gives you. And then maybe like a kind of a belly of the curve portfolio, five to seven years can provide you some of the income. And by the way, it's not just treasuries, of course, it's credit. And it could be public and private credit. It can be infrastructure yielding product. Okay. It can be real estate. So I don't want people to walk away saying I should own all gold because you get no yield. And yield is a very important part of any asset owner's portfolio particularly if you're retired. Some people were a little surprised at the headline. But when you explain it like that then I think people get the joke. And of course when I made the comment that was like the beginning of the big final move here to whatever 5600. So timing is everything. I didn't expect that to happen that quickly, but here we are.