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Don’t overreact to higher trailing inflation.

Portfolio > Economy & Markets

Morgan Stanley Expects This Shock to Kill Rally

By Richard Henderson

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Morgan Stanley strategists anticipate a sudden pullback in corporate earnings will slam the brakes on a U.S. equity rally, a call at odds with Wall Street estimates.

Instead, they are bullish on equities in Japan, Taiwan and South Korea and recommend an overweight position in developed-market government bonds, including long-dated Treasuries, and the dollar.

Earnings per share for the S&P 500 are set to drop 16% this year, according to Morgan Stanley strategists led by Andrew Sheets.

That’s one of the most bearish predictions among those tracked by Bloomberg, and contrasts with bullish forecasts from the likes of Goldman Sachs Group Inc., which anticipates mild growth.

“We think that the downside risk to US earnings is now,” Morgan Stanley analysts wrote in a note published Sunday. “While a deteriorating liquidity backdrop is likely to put downward pressure on equity valuations over the next three months, we also see EPS disappointment ahead as revenue growth slows and margins contract further.”

Morgan Stanley anticipates that S&P 500 earnings per share will come in at $185, compared with a median $206 prediction from strategists. Sheets’s team sees the gauge at 3,900 at year-end versus Friday’s close at 4,282.37.

The benchmark is on the edge of a bull market following a 19.7% rally from an October low, gaining amid enthusiasm for artificial-intelligence stocks despite rate hikes from the Federal Reserve and concerns about a potential recession.

Other recommendations from the bank’s strategists include defensive stocks, developed-market investment-grade bonds, and for yield-hungry investors a preference for additional tier-one securities — a type of subordinated bank debt — over high-yield bonds.

Bloomberg chart showing Earnings Estimates Recover as Stocks Rise | Morgan Stanley strategists say sudden profit drop to weigh on equities

To be sure, some strategists are more optimistic than those at Morgan Stanley. An Evercore ISI team led by Julian Emanuel raised their S&P 500 target for the year-end by 7.2% to 4,450.

They said easing inflation likely signals a Fed pause and that dollars “delivered during the pandemic’s darkest days” will support the stock market.

Here are more views from Morgan Stanley strategists:

  • European stocks may drop as much as 10% over the next few months, though the downside risk is limited due to attractive valuations.
  • Europe will eventually benefit from a rotation into international cheaper, so-called value, stocks and away from US growth shares
  • In Asia, the bank’s strategists became the latest China bulls to reduce the target for key stock indexes, citing a delayed earnings recovery, weaker currency outlook and geopolitical uncertainties.

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