With inflation falling from its 40-year high in June, investors are betting the Federal Reserve will end its interest rate hiking cycle and “pivot” to rate cuts this year, juicing markets like they did in the past. But some top Wall Street strategists warn that the rosy outlook for stocks may be overly optimistic.
Morgan Stanley’s chief investment officer and chief U.S. equity strategist, Mike Wilson, believes the Fed will keep rates higher for longer, and that corporate earnings will fall.
“Once people realize the Fed’s not cutting rates—there’s no more heroin, so to speak—then we’re going to price the fundamentals, which are clearly deteriorating in our view,” he told CNBC Tuesday.
Wilson argues Fed Chair Jerome Powell will “hold firm” and keep raising interest rates this year, arguing that there is “no incentive” for him to cut rates with the labor market remaining strong and China’s reopening after COVID lockdowns helping to boost inflation.
“I think they’re going to do their job. Jay Powell is here to make sure he gets inflation down,” Wilson said, noting that rising commodity prices this month will give the Fed chair ammunition to keep rates higher.
After the S&P 500’s more than 6% rally in January, Wilson believes that markets are looking “frothy” as well—a term used to indicate that stocks are trading at valuations above their fundamentals—arguing that investors are walking into another bear market trap if they buy at these levels.
“There’s this narrative that China’s reopening and inflation has peaked. We can look through the valley here and start buying early cyclical stocks. I think that’s a real mistake, given the degradation in earnings that we think is coming,” he said.
Over the past few months, Wilson has repeatedly made the case that a growing number of U.S. corporations are experiencing negative operating leverage (NOL), which, simply put, means costs are rising faster than sales growth.
“Nobody saw inflation coming, they all benefited from it, and now they’re underestimating the negative operating leverage cycle,” the CIO warned on Tuesday.
In a Sunday note, Wilson explained that costs are rising faster than sales growth in about 80% of S&P 500 industry groups this earnings season, leading profit margins to sink. As inflation and consumer demand fall this year, Wilson says that companies are struggling to get rid of “sticky costs” and rightsize their businesses.
He noted that from tech companies like Microsoft and Intel to the defense giant Lockheed Martin and the toy company Hasbro, negative operating leverage and falling margins were key themes in many fourth-quarter earnings calls.
”We see confirmation of our negative operating leverage thesis, with many companies meeting sales expectations but posting significant misses on earnings,” he wrote, adding that corporate guidance for future profits and revenue is also “coming down.”
Wilson believes that investors should avoid U.S. equities until earnings “reflect something closer to reality” and valuations fall. Even after January’s rise, he expects stocks to drop roughly 25% to 3,000 in the first half of this year, before recovering to 3,900 by year's end.