While the Fed fights generationally high inflation, the U.S. economy continues to grow, supported by high levels of spending. This has affected both the bond and equity markets.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, August 14, at 11 a.m. in New York. So let's get after it.

At the trough of the pandemic recession in April 2020, we first introduced our thesis that the health care emergency would usher in a new era of fiscal policy. The result would be higher inflation than monetary policy was able to attain on its own over the prior decade. In the first phase of this new policy regime, we referred to it as helicopter money, as described by Milton Friedman in the early 1970s and then highlighted by Ben Bernanke after the tech bubble as a policy that could always be employed to avoid a deflationary bust. Handing out checks to people is a fairly radical policy, however, the COVID pandemic was the perfect emergency to try it.

The policy shift worked so well to keep the economy afloat during the lockdowns that the government decided to double down on the strategy by doing an additional $3 trillion of direct fiscal spending in the first quarter of 2021. This excessive fiscal policy is why money supply growth increased to a record level at 25% year-over-year in early 2021, and why we finally got the inflation central banks had been trying so hard to achieve post the great financial crisis. After the financial crisis, the velocity of money collapsed, while the Fed's balance sheet ballooned to levels never seen before. The reason we didn't get inflation in that initial episode of quantitative easing is because the money created remained trapped in bank reserves rather than in a real economy where it could drive excess demand in higher prices, a dynamic that's been obviously very different this time.

Fortunately, the Fed is responding to this generationally high inflation with the most aggressive tightening of monetary policy in 40 years. But this is the definition of fiscal dominance, monetary policy is beholden to the whims of fiscal policy. First, it had to be overly supportive and fund the record deficits in 2020 and 21, and then it had to react with historically tighter policy once inflation got out of control. Back in 2020, we turned very bullish on equities on this shift of fiscal dominance and also subsequently indicated it would lead to a period of hotter but shorter economic earning cycles, mainly because the Fed would not have the same flexibility to proactively try to extend economic expansions. We also argued that catching these cycles on both the upside and downside would be critical for equity investors to outperform. From 2020 to 2022, we found ourselves on the right side of that dynamic both up and down, this year, not so much. Part of the reason we found ourselves offsides this year is due to the very large fiscal impulse restarting last year and remaining quite strong in 2023. In fact, we have rarely ever seen such large deficits when the unemployment rate is so low and inflation well above target.

If fiscal policy is showing little constraint in good times, what happens to the deficit when the next recession arrives? The main takeaway for the equity market this year is that fiscal policy has allowed the economy to grow faster than forecasted and has given rise to the consensus view that the risk of recession has faded considerably. Furthermore, with the recent lifting of the debt ceiling until 2025, this aggressive fiscal spending could continue. However, the sustainability of such fiscal policy is the primary reason why Fitch recently downgraded the U.S. Treasury debt. Combined with the substantial increase in the supply of Treasury notes and bonds expected to fund these government expenditures, bond markets have sold off considerably this past month. This should start to call into question the valuations of equities, which were already high even before this recent rise in yields. Furthermore, if fiscal spending must be curtailed due to either higher political or funding costs, the unfinished earnings decline that began last year is more likely to resume as our forecast is still predicting. Equity markets seem to have noticed, with many of the best performing stocks correcting by 10% or more. Even if one is bullish on stocks, such a correction was necessary to reset investor exuberance. The challenge will come this fall if growth fails to materialize as now expected. In that case, a healthy 5 to 10% pullback may turn into the much more significant correction we were expecting to occur in the first half of this year.

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