“Be careful what you wish for.”
That’s Morgan Stanley’s Mike Wilson, chief U.S. equity strategist, warning investors on Wednesday of the hazards of cheering recently cooler inflation data.
While price pressures have pulled back from peak levels last summer, easing, “especially for goods, is a sign of waning demand,” Wilson said in a new client note, adding that “inflation is the one thing holding up revenue growth for many businesses.”
If revenues start to fall short of expectations, “earnings could see a gradual, then sudden, slide,” Wilson wrote, riffing off what a character in Ernest Hemingway’s book, “The Sun Also Rises,” said about going bankrupt.
His main takeaway? Just as the collapse of Silicon Valley Bank and Signature Bank caught investors off guard, despite the reality that rapid rate hikes would erode the value of low coupon bonds held by banks, so could an earnings recession “take investors by surprise.”
Stock have been moving little this week, despite a pickup in quarterly earnings. The Dow Jones Industrial Average
DJIA,
-0.23%
shed about 80 points on Wednesday, but the S&P 500 and Nasdaq Composite Index
COMP,
+0.03%
were mostly unchanged for a second straight session.
In addition to earnings, investors have been focused on when the Federal Reserve might stop raising rates, or potentially even switch gears to cut them. The Fed’s high end of its policy rate range hit 5% in March, up from nearly zero roughly a year ago.
Read: Why bears can’t keep the stock market down despite bad news
The thinking goes that rate cuts, while likely in response to a faltering economy, could pave the way for stocks to recover lost ground. The S&P 500 index
SPX,
-0.01%
shed slightly more than 25% from its peak level in January 2022 to its October 2022 trough. But it was up about 8.2% on the year through Wednesday, according to FactSet.
Still, the rally in stocks “should not necessarily be viewed as a signal that all is well,” Wilson wrote. “On the contrary, the gradual deterioration in the growth outlook for U.S. stocks is likely to continue. And even large-cap indices are at risk of a sudden fall, like those we have witnessed in the regional banking index and small caps.”
Shares of Tesla Inc.
TSLA,
-2.02%
fell 5% in the extended session on Wednesday after the electric-vehicle maker narrowly missed quarterly revenue expectations, and after it announced another round of U.S. price cuts to its vehicles to boost demand.
The S&P 500 was reporting an earnings decline of 6.5% from a year ago, which would be its largest annual decline since its 31.6% drop in the second quarter of 2020, according to FactSet data as of April 14.
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