Falling Inflation A Deceptive Harbinger Of Doom; Analyst Warns Earnings Expectations Are Too High

Morgan Stanley's chief U.S. equity strategist and chief investment officer Mike Wilson said that U.S. equities are likely to witness a short-term blow given the risks of further Federal Reserve rate hikes and declining corporate earnings.

The S&P 500 index, which is tracked by the SPDR S&P 500 ETF Trust SPY, has rallied 7% since mid-March, while the tech-heavy Nasdaq 100, tracked by the Invesco QQQ Trust QQQ, has fared even better, rising nearly 10% since its March lows. 

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Wilson sees a near-term threat to stock prices due to a more pessimistic earnings outlook, especially as the liquidity picture becomes less accommodating.

“Net-net, the data suggest to us that the business cycle is continuing to slow and that consensus EPS expectations for 2023 remain materially too high,” he wrote in a report published on Monday. 

The analyst notes that historically, the Fed has tended to lower rates instead of raising them when projected EPS growth becomes negative. However, the present economic environment, characterized by inflation, has made this cycle an unusual departure from past trends in this respect.

Credit Crunch Building Up

Wilson stated on a Morgan Stanley podcast last week that early symptoms of a credit crunch have begun. More precisely, the analyst noted that banks' biweekly lending fell by the most on record, as they sold mortgages and treasuries at a record rate to counter deposit flight.

"Our contention is that the major averages are hanging around current levels due mostly to their defensive and high quality characteristics. However, that should not necessarily be viewed as a signal that all is well," he said. 

As revenue growth begins to disappoint, Morgan Stanley anticipates the rate of decline in consensus earnings per share estimates for the S&P 500 to accelerate significantly over the next few months.
Wilson ultimately cautioned investors not to be overly euphoric about lower-than-anticipated inflation.

"Falling inflation, especially for goods, is a sign of waning demand, and inflation is the one thing holding up revenue growth for many businesses," the analyst said. 

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