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Action by Congress and the Fed, and its absence, has paved the way for the recent downturn in equities, putting markets back on a more sustainable footing, Chief Investment Officer at Morgan Stanley Mike Wilson explains.

Key quotes

“It looks like Congress is having a difficult time coming to terms on the next round of fiscal stimulus. It’s not that either side is unwilling to spend more money, it’s how much and where does it go. What that really means is both sides want to make sure they get credit from voters in November. But markets are impatient and are likely to exert pressure on Congress to get the deal over the goal line, which may take a few more weeks. The unfortunate and unexpected passing of Supreme Court Justice Ginsburg is also likely to further cloud this ongoing negotiation.”

“In the past few months, the Fed has changed its strategy in terms of exactly how it will support the recovery going forward, and that has come as a bit of a surprise to markets. They have moved to what is called an ‘average inflation targeting’ regime. What that means is that the Fed will not raise interest rates even as inflation rises above its 2% goal. However, what they have not committed to is keeping longer-term interest rates lower via Treasury bond purchases. And last week they reaffirmed that stance and made it even clearer by not providing any definitive guidance in its quantitative easing program.”

“While all equities are long-duration assets depending on ten-year yields, expensive growth stocks with cash flows further out in the future are the most vulnerable to rising back end rates. Compounding that risk is the fact that many of these stocks became overpriced in August on the view that long-term rates were never going higher. This is why the Nasdaq has underperformed so much in this recent correction and is likely to continue until the stocks reflect this risk of higher long term rates. I estimate that’s another 10% downside from here for major equity markets and perhaps 15% for the Nasdaq.”

“This will be a buying opportunity for those who have cash or those who missed the first powerful leg of this new bull market. We continue to focus on those companies that can deliver better than expected earnings growth next year. This includes a mix of companies most levered to the reopening of the economy and a select group of growth stocks once they better reflect the risk of higher rates.”