Earnings season will be a key test for the stock market after the S&P 500 last week closed out its worst half-year performance since 1970, said strategists from Morgan Stanley.
The direction of stocks going forward will be mostly tied to second-quarter earnings as interest rate hikes and surging inflation reflect the growth slowdown more accurately, according to a Morgan Stanley MS, -0.83% report on Tuesday.
“We are firmly in the midst of the economic slowdown we expected,” wrote strategists at Morgan Stanley led by Michael Wilson, chief investment officer, in a client note. “Furthermore, due to the war in Ukraine and China’s extended zero covid policy, this slowdown is even worse than we expected.”
“We believe most investors are also now in our camp and trying to determine how much earnings need to fall,” they wrote. “…In short, stock prices should be determined more by earnings than the macro going forward.”
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Earnings season gets under way next week as results roll in from PepsiCo Inc. PEP, -0.22%, Delta Air Lines Inc. DAL, +1.02%, JPMorgan Chase & Co. JPM, -0.38% and Morgan Stanley MS, -0.83%, with the pace then picking up.
“Equity markets could hang around, and even rally in the absence of a confirmation of a recession,” the strategists wrote. “Conversely, in the absence of confirmation a recession will be avoided, it will also be difficult for equity markets to rally too far. As we have discussed, earnings are too high even in the soft landing outcome.”
Under that scenario, Morgan Stanley expects the S&P 500 SPX, +0.16% to reach a fair value target of approximately 3,400 to 3,500. However, if the economy ends up in recession, the index could sink to 3,000 points late this year — “a temporary overshoot of our bear case point in time June ’23 price target of 3350,” they wrote.
The large-cap benchmark erased an early fall to eke out a 0.2% gain on Tuesday at 3,831.39, leaving it down 19.6% year to date, after U.S. markets were closed Monday for the July Fourth holiday. The Dow Jones Industrial Average DJIA, -0.42% finished nearly 130 points lower, down 0.4%, after dropping more than 700 points at its session low, while the tech-focused Nasdaq Composite Index COMP, +1.75% jumped 1.7% as Treasury yields fell.
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Other strategists said investors are waiting to see earnings, and even more important, corporate guidance.
“The ongoing search for clues as to whether the second half of the year can see the market stage a strong recovery will begin with what companies have to say during their second quarter earnings calls,” wrote Quincy Krosby, chief equity strategist at LPL Financial, in an email. “Although negative earnings revisions are increasing, overall expectations for the second quarter remain surprisingly solid despite ongoing constraints affecting corporate operating margins.
However, Morgan Stanley warned investors that companies at this stage of the economic slowdown may see divergent paths and may provide conflicting signals to investors.
“Our experience is that the higher quality companies will admit the problems earlier and set expectations appropriately given the deteriorating macro environment,” they wrote. “But this process can take longer than it should, and this time is likely no different.”
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