A new COVID variant may cause 'central banks to be more cautious': Morgan Stanley strategist

Morgan Stanley Strategist Andrew Sheets discusses the outlook his company projects for several markets and ways in which the new Omicron COVID-19 variant could influence American and foreign markets and the Fed's inflation policy.

Video transcript

BRIAN SOZZI: All right, the latest COVID variant has caused investors to wake up to the ongoing risk that the pandemic presents. So will COVID concerns derail the bull market in 2022? Andrew Sheets is the Chief Cross Asset Strategist at Morgan Stanley and joins us now. Andrew, good to see you, as always, here. Really, Friday, tough session here. Does that derail what you are thinking about with the market next year? And what are some of your views?

ANDREW SHEETS: Yeah, thanks. It's great to be here. So, look, I mean, I think, with all honesty, it's still very early when thinking about the implications of this variant. There's key information that we do not yet know, and that information could determine how severe things are, so we tend to take a step back. You know, I think you had a global economy that in the fourth quarter up through last week was looking incredibly strong.

Morgan Stanley's growth tracker for fourth quarter GDP was above 8%. So you had very strong growth, high readings on inflation, a lot of pressure building on central banks to act. And then a new variant comes along, and that would seem to kind of work against a lot of the trades that would work in that high-growth environment, and also seem to kind of disrupt even some of this, you know, "do central banks need to act more aggressively" narrative, because if there's a new variant, then maybe they should be more cautious.

So it's coming at an important time for the market. I think there are real questions about transmissibility, around how dangerous the variant is, can it evade the vaccines or partially evade. But I think, at the moment, the way that I would summarize our first thoughts is it doesn't change the longer-term outlook. It might disrupt how we get there.

If we think about 2021, Delta disrupted how we got there, but the full year was still relatively strong for growth, and markets reflected that. So it's, so far, not changing that base case view.

JULIE HYMAN: So Andrew, it's Julie here. Let's talk about the base case a little bit more then, and your longer-term outlook. Because you guys were just out with your outlook recently for 2022, and you talk about a moderating inflation picture. But at the same time, you say there is downside risk for the S&P 500. What's the sort of origin of that risk, or the main origin of it?

ANDREW SHEETS: Yes, that's a great question. So our target for the end of next year for the S&P 500 is 4,400, lower than today. And that certainly raises some eyebrows. It is not because of earnings. At Morgan Stanley, we're pretty optimistic on the S&P 500. We think earnings are going to be better than consensus over the next two years. So then the question is, well, how does the market move lower. And it's entirely a function of the valuation, we think, that gets applied to those earnings.

So you've seen almost every other equity market in the world see its valuations fall over the last year, or fall back towards the five-year average, which is a very normal occurrence after recession as the economic cycle starts to advance and mature a little bit. And the S&P is kind of unique in that it hasn't done that. And so we think that it eventually does have to catch up. That the Fed is going to be stopping its bond buying by the middle of next year. That you're seeing a more normalizing environment by-- certainly by the end of next year.

And all of those factors, normalizing policy, I think some increased uncertainty around-- will tax policy change? The fact that we think interest rates will go higher. All of those justify a valuation that would still be high by historical standards. We're kind of 18, 18 and a half times. But lower than where it is today.

BRIAN CHEUNG: Andrew, Brian Cheung here. I want to ask about the central bank angle of things that you kind of teased at the top of your kind of hit here. Now, obviously, when it comes to the positioning that we've had so far, it seems like banks or central banks around the world are more in favor of trying to withdraw the accommodation than keep it going full pedal to the metal right now. Do you think the omicron variant changes that, despite the fact that we've even seen some of the more dovish members, including San Francisco Fed president Mary Daly here stateside, hinting that they also would like to prefer a pullback in accommodation?

ANDREW SHEETS: Yeah, Brian, so I think that's a great question, because it's coming at a very kind of awkward time. So I think, you know, for a lot of the last year and a half, I mean, the market has been uncertain, the economy has been uncertain, but I think in some ways you could say the job of the Federal Reserve has been pretty straightforward. You know, inflation was low, the economy was weak, unemployment was high, there's a global pandemic. Of course you're going to provide enormous accommodation.

What else could you do? Well, we've seen a big normalization in the economy, now the inflation numbers have started to pick up-- all things that historically suggest policy should also start to normalize. And then here comes another variant, which may or may not introduce downside risk to that picture. So I think the December Fed meeting is going to be very important. I think something to watch out for is, does the Fed try to split the difference, to say, look, we're going to slow down the bond buying, maybe even faster than what we were saying before so we don't need-- we're not going to buy as many bonds as before, but we're still going to keep our rates very low. We're still going to delay the first rate hike.

That, I think, would be an important kind of divergence to watch for. Our base case at Morgan Stanley is that the Fed will not hike interest rates next year. That's different from the consensus, which is expecting at least one hike. But we ultimately think the Fed will be patient, as some of those inflation numbers moderate over the course of next year.

JULIE HYMAN: Yeah, that's interesting as well-- your outlook for stocks even without the Fed hiking rates, just with it doing the taper. Finally, I do want to ask, if you don't like US stocks going into next year-- I saw it from your note. You guys are looking elsewhere, equities wise, to places like Europe and places like Japan. Europe to me is interesting in particular, given kind of where they are in their rate cycle versus here, and also where they are in their COVID cycle versus the US. So talk to me about Europe in particular and why you guys like it.

ANDREW SHEETS: Yeah. So I think that's-- you have two, I think, really kind of interesting dynamics with Europe and Japan, which I'll talk about a little bit together, even though they're obviously different, and the US. So one is this question of valuation adjustment. And you know, in Europe and Japan, you've seen those markets already have their valuations fall back down to kind of where they were in late 2016. So again, it's an open question.

Do valuations need to come down as interest rates start to go up and central bank policy shifts? We don't know. We think it would be reasonable. More of that valuation adjustment has already happened in those regions, so we think it's less of a risk going forward. And then the second is monetary policy. So you know, as you alluded to, even though we don't think the Fed raises interest rates next year, you know, we think the market's forward looking, that the writing's on the wall.

And so it's going to say, look, whatever the Fed doesn't do next year, they're just going to do in the year after that or the year after that. And you do have higher inflation in the US than in Europe and Japan. You have significantly higher in certain cases. And so for all those reasons, we think the risk or the scenarios where interest rates rise a lot more in the US is just a lot more likely than a scenario where interest rates rise a lot in Europe and Japan. So that's one issue that might be more-- might come up for US assets and US stocks that seems a lot less likely to come up for stocks in Europe and Japan.

BRIAN SOZZI: Point well taken. Andrew Sheets, Chief Cross Asset Strategist at Morgan Stanley. Good to see you.