Market March Madness: Morgan Stanley Shows How "The Big Flip" Changed Everything

By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley

The NCAA basketball tournament (“March Madness”) is one of my favorite sporting events of the year. With 64 teams in single elimination, it makes for some wonderful chaos.

As a sport, college basketball seems uniquely affected by "momentum". A team that looks unstoppable over one stretch suddenly forgets how to shoot over the next. Momentum often shifts during a game, creating real tension as things swing back and forth.

Which brings us to markets.

January and February saw strong, overlapping signals that the global economy was in a healthy place, boosted by cheap energy, stimulative policy, and robust tech investment.

Oil prices were falling as metals, transports, cyclicals, and financial stocks rallied. Europe, Asia, and EM, all more sensitive to global growth, outperformed. Inflation moderated. Central banks were planning to cut rates. The yield curve bull-steepened and the dollar weakened. The January US jobs report was good. Every shot was going in.

In an instant, the Iran conflict and the risk of an oil shock reversed the narrative. Oil rose while metals, transports, cyclicals, and financials fell. Equities in Europe and Asia dropped sharply, given their reliance on imported energy. The dollar strengthened as investors sought havens, inflation expectations rose, and curves bear-flattened as rate expectations shifted rapidly.

And, as yet another shot bricked off the iron, recent US data showed negative job growth and higher core inflation. The momentum has swung hard.

This "big flip" extends beyond performance into fundamental macro mechanics.

1. The first is in central banks, where the last two weeks saw the Fed, Bank of England, and ECB all shift and sound more concerned about inflation.

This reversal was especially striking for the ECB, which used modelling heavily informed by the 2022-2023 energy shock in its recent projections. As of this writing, the market is pricing ~85bp of ECB hikes by year-end.

2022-23 is a recent example of a severe energy shock. But it involved other, different dynamics (COVID stimulus, disrupted supply chains, a very tight labor market, and a big shift of spending from goods to services). Meanwhile, investors are aware of previous instances of oil-driven inflation prompting rate hikes despite growth risks (July 2008 and April/July 2011). Neither ended well for risky assets.

The prospect of higher energy prices and tighter policy works against European assets, especially as the Fed is more likely to stay on hold or move to lower rates if conditions worsen. We prefer US over Europe in both equities and credit.

2. A second mechanism, linked to the first, is that this shock challenges strong market "technicals".

For example, YTD credit flows have been strong, and the conventional view (which we have shared) is that higher yields would support even more credit demand. But 2022 showed that these flows can weaken and reverse if central banks turn more hawkish and curves flatten. Those risks are rising, especially in Europe.

3. And then there’s the fact that oil-producing countries are also important investors, across a range of asset classes.

If oil flows slow, that source of funds may slow with it. Our US Rates Strategists recently explored this theme for the Treasury market.

If the Iran conflict ends and oil shipments resume through the Strait of Hormuz, momentum could swing back again, and we note that strong underlying fundamentals should make this business cycle unusually resilient. A full set of our views across re-opening scenarios is here. But until hostilities cease, the speed and scale of this flip has sapped performance, and left investors in a difficult position.

Coupled with the difficulty of diversification, where stocks, bonds, and gold have all moved together, the path of least resistance may be to reduce risk and increase liquidity. In that environment, conditions can remain volatile before they improve. At least there’s basketball on.

Much more in the full Morgan Stanley Sunday Start note, all linked reports also available to pro subs.