Will optimism hold as earnings season gets fully under way this week and is banking stress done? Our call of the day, from Morgan Stanley’s chief U.S. equity strategist Mike Wilson, warns of a long shadow cast by March stress, despite a mostly upbeat stock market.
“In contrast to what we expected, the S&P 500
have traded well since SVB [Silicon Valley Bank] first announced it was insolvent. However, small-caps, banks and other highly levered stocks have traded poorly as the market leadership turned more defensive, in line with our sector and style recommendations,” Wilson tells clients in a new note.
The strategist credits “defensive/high-quality characteristics and lower back-end rates” for holding up bigger indexes, but warns against breathing easy here. “On the contrary, the gradual deterioration in the growth outlook continues, which means even these large-cap indexes are at risk of a sudden fall like those we have witnessed in the regional banking index and small-caps,” says Wilson.
He uses a quote from one of Ernest Hemingway’s novels to get his point across. In “The Sun Also Rises,” a character, asked how he went bankrupt, responds: “Two ways…Gradually, then suddenly.” Last month’s bank failures were blamed on a gradual build up of risk from long-duration Treasury holdings and concentrated deposit over the past year that suddenly accelerated, noted Wilson. And as most didn’t see those coming, investors need to stay alert for more fallout, he warns.
One area to watch — earnings and a “gradually, then suddenly,” decline in estimates. Since last June’s peak, the forward 12-month bottom-up consensus earnings per share (EPS) S&P 500 forecast has fallen by around 9% per annum, “which is not severe enough for equity investors to demand the higher equity risk premium we think they should,” says Wilson. And he is neither swayed by consensus earnings forecasts that imply the first quarter will mark an EPS trough — usually a buy signal.
Last week’s bigger-than-inflation drop may also pose trouble for companies, as it hints of sagging demand, as “inflation is the one thing holding up revenue growth for many businesses,” says Wilson.
“The gradually eroding margins to date have been mostly a function of bloated cost structures. If/when revenues begin to disappoint, that margin degradation can be much more sudden, and that’s when the market can suddenly get in front of the earnings decline we are forecasting, too,” he said.
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The financial sector stays in the spotlight as earnings season heats up with Charles Schwab
reporting. The rest of the week will see Bank of America
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Morgan Stanley strategists have recently argued that earnings expectations for companies are about to drastically decrease, a quote commonly referred to as “Gradually, then suddenly” when applied in other contexts.
Their insight is based on various indicators, such as current market fluctuations, soaring energy and material costs, slowing down of technological advances, and two quarters of declining economic growth. Morgan Stanley has emphasized how common it is for economic growth to slow down after a certain period of expansion.
The slowing of growth combined with the aforementioned elements will have serious negative implications for companies’ earnings. The strategists argue that corporate cases of earnings disappointments will start off slowly but will soon become much more frequent and dramatic.
Much of the current market is based on market optimism and the false belief in perpetual growth, according to Morgan Stanley strategists. This means that market sentiment will become strongly affected if these expectations of slowing growth turn into reality and companies start to decrease their numbers.
The strategists warn that the worst is yet to come and call upon investors to look beyond the current period of calm and pessimistic anticipation of the future.
In conclusion, Morgan Stanley strategists have warned that earnings expectations are likely to see a considerable reduction in numbers in the near future. Investors should be prepared for the sudden de-acceleration if these predictions prove to be true.