Morgan Stanley: Markets are too optimistic

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By Robert Zach

AiVIF.com - Despite fears of a recession reflected in the deep inversion of the yield curve, the U.S. stock market has so far maintained many of its recent recovery gains. Since its lows in October, S&P 500 was up about 12% through yesterday, narrowing its year-to-date losses to 16%. At 3,995 points, the U.S. leading index is trading just below the psychologically relevant 4,000-point mark and within striking distance of its smoothing of the last 200 days (currently at 4,032). U.S. bank Morgan Stanley sees only one problem: corporate profits.

According to Lisa Shalett, chief investment strategist at Morgan Stanley Wealth Management, the market is still pricing corporate earnings too high. Equity investors' optimism, based on hopes that the Fed can slow the economy enough to lower inflation without triggering a recession, "…optimism is reflected in consensus 2023 corporate earnings estimates for the S&P 500 Index at $230 per share.," she wrote in a note Monday.

Morgan Stanley counters that, however: That's because even without a recession, corporate profits would fall due to declining sales and lower pricing power, which is why the U.S. bank lowered its 2023 earnings estimate to $195 per share, the expert said.

"When we consider factors such as the Purchasing Managers’ Index (PMI) data, the yield curve and correlations between profit growth and the speed of the Fed’s rate hikes, we anticipate that 2023 year-over-year earnings growth will likely be materially negative," Shalett wrote.

At current consensus estimates of $230 per share, the expected price-to-earnings ratio for the S&P 500 (currently at 3,995 points) is 17.4. If we now take the average P/E ratio in recessionary periods (14.5) and Morgan Stanley's earnings estimates, that would result in an S&P 500 level of about 2,830 points.

Morgan Stanley does outline two scenarios in which Corporate America could avert a decline in corporate earnings. But these are not very likely, according to the analyst.

First, she points to corporate cost-cutting measures, such as job cuts, that could offset a decline in sales. However, this is a "double-edged sword," Shalett said. "Rising unemployment constrains consumer spending—a key driver of economic growth—and risks a "hard landing" for the economy overall," she added.

In the second scenario, she highlights the strength of the U.S. labor market, where the unemployment rate is still near a record low of 3.7%, and the robustness of the U.S. consumer, which could keep corporate profits high in 2023. But on the other hand, this could spur the Fed to further hefty rate hikes and ensure that high interest rates are maintained for a longer period of time, which in turn would "put more of a drag on the economy."

The Fed yesterday raised its benchmark rate by another 50 basis points to the range of now 4.25% to 4.50%, but at the same time revised upward its forecast for the 2023 rate peak to 5.1%. That's 50 basis points more than in the September projections. Fed Chairman Jerome Powell said at his press conference after the rate decision that rate cuts are not an issue next year. The market had previously expected the first rate cuts toward the end of 2023. "Our focus right now is really on moving our policy stance to one that is restrictive enough to ensure a return of inflation to our 2% goal over time, it's not on rate cuts," Reuters quoted the Fed chief as saying.

The Morgan Stanley expert advises against passive investments in U.S. equity indices. Investors should sell these at a loss before the end of the year in order to benefit from so-called 'tax-loss harvesting', in which accrued income is converted into long-term price gains. Instead, she advises high-yield investments such as government bonds, municipal bonds, corporate bonds, and master limited partnerships (MLPs), but selected dividend stocks, value stocks, and REITs may also be of interest.

(Translated from German)