S&P 500 at 3900? An 'easy' sell - Morgan Stanley

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By Senad Karaahmetovic

S&P 500 closed over 2.2% higher last week, buoyed by softer-than-expected wage growth in the U.S. While the unemployment rate fell to a pre-pandemic low of 3.5%, investors instead opted to focus on a moderation in wage gains.

A strong labor market is supporting the U.S. economy and sustaining consumer spending. Given that the Fed remains committed to keeping high rates until there is clear evidence inflation is going back to its long-term target of 2%, the markets welcomed the slowdown in wage growth.

However, equity strategists - including at Morgan Stanley - continue to urge investors that valuations remain elevated amid wide expectations that earnings estimates cuts for the S&P 500 are set to continue for Q4.

“Back in August, we first warned that peaking inflation is a positive for bonds, but it's also very negative for profitability. Since then, margins have disappointed across many sectors, and we expect more of this theme in 4Q results and throughout 2023. High inflation increases operating leverage, all else equal, and operating leverage cuts both ways. This is in stark contrast to the other popular narrative we hear from the buy and sell side—i.e., that higher inflation is good for nominal GDP and, therefore, revenues and profits,” they wrote in their regular weekly note to clients.

While the strategists acknowledge that both sell and buy side consensus are aligned - looking for the weaker first half of 2023 followed by a rally - they warn that we may witness a worse-than-expected decline in the coming months.

“Our concern is that most are assuming "everyone is bearish" and, therefore, the price downside in a recession is also likely to be mild (SPX 3,500-3,600). On this score, the surprise might be how much lower stocks could trade (3,000) if a recession arrives.”

“We don't think a 3,500-3,600 S&P 500 is consistent with the consensus view for a mild recession. That is one way the consensus could be right directionally, but wrong in terms of magnitude,” the strategists added.

Given the expected earnings estimates revisions to the downside, as well as the Fed’s commitment to continue fighting inflation, they conclude that the S&P 500 trading near 3900 makes it “an easy sale.”

As of 05:10 ET (10:10 GMT), S&P 500 futures are up 0.40% in pre-market Monday, trading around the 3910 handle.