Morgan Stanley strategists issued a note looking at the market vs how investors are viewing economic conditions.
The dip in bond yields recently indicates investors feel it is likely the Fed will let up on interest rate hikes if inflation is peaking in the second half of the year, however Morgan Stanley analysts led by Michael J. Wilson write that “any fall in rates should be interpreted as more of a growth concern rather than as potential relief from the Fed.”
As investors worry that surging inflation is combining with an aggressive Fed bent on attacking it to cool the economy and trigger an economic contraction, the S&P is seeing some of its worst trading in over 50 years. At this point the fears of a recession are priced in, but not the certainty. So if the macroeconomic data were to not show the onset of a recession it is likely the markets would begin a rally. However if growth does show a contraction, it is likely that the S&P 500 could drop to 3,000, which would be 22% below the close Friday.
Wilson’s point is, given the Fed’s state aggression in tackling inflation, were the Fed to back off on interest rate hikes, that should be interpreted as more of a troubling sign that the Fed was seeing ominous signs, rather than indication that the worst was behind us and inflation had been dealt with.
Wilson is known on Wall Street as one of the more bearish analysts, however he correctly called this year’s selloff. In his opinion the S&P 500’s fair market value is about 11% lower than it is now, at about 3,400 to 3,500. He believes that from this point, stocks will likely be driven by second quarter earnings as equity risk premiums and interest rates begin to reflect the ongoing growth slowdowns more precisely.
Wilson points out that the S&P 500 and Nasdaq 100 forward earnings estimates are over 20% more than the post-global financial crisis trend. That would indicate that those expectations will have to be cut in the next quarter, before all of the bad news is priced in and the market can then move forward, and begin to advance reliably again. He said, “Until earnings estimates are cut to more reasonable levels or valuations reflect that risk, the bear market is not complete.”
He noted that as we head into uncertainty for now, the market is favoring earnings stability and defensive industries, like telecoms, utilities, insurance, real estate, some parts of consumer staples and health care. Other industries which are dependent on economic activity, or which are prone to see profits fluctuate, like tech hardware or semiconductors, are at greater risk, and should be avoided until there is some market stabilization.
