Morgan Stanley says economy-tied stocks to weaken

A dimmer outlook for US corporate earnings is likely to hurt stocks that are tied to the economy, as investors worry about the impact of falling inflation on pricing power, according to Morgan Stanley’s Michael Wilson.

The strategist — who was among the biggest bearish voices on US stocks last year — said that a gauge that measures profit upgrades versus downgrades has turned weaker, as is typical for this time of the year. That’s being driven primarily by so-called cyclical sectors.

“In our view, this does not offer support for a broad cyclical rotation,” Wilson said, adding that the market was “also potentially focused on the notion that falling inflation may prove to be a headwind for cyclicals, which are highly dependent on pricing power.”

The rally in US stocks has faltered since the benchmark S&P 500 Index hit a record high in mid-July on concerns that a slowing economy will prompt the Federal Reserve to cut interest rates faster and deeper than expected. Markets are now fully pricing in a rate reduction by September, according to swaps data.

A Citigroup Inc. basket shows earnings downgrades have broadly outnumbered upgrades since late June. Meanwhile, cyclical stocks in the S&P 500 have underperformed the relatively safer defensive sectors since April.

The biggest technology stocks have also suffered in the latest selloff, with investors preferring smaller stocks that are cheaper. Morgan Stanley’s Wilson said he continued to recommend large-cap stocks, “though we are watching the fundamental and technical backdrop for small caps closely.”

“For now, we continue to think the better risk/reward within small caps is growth equities, which should benefit from a cost of capital standpoint as the Fed cuts” rates, Wilson said.

RBC Capital Markets strategist Lori Calvasina also said trends in earnings revisions don’t yet support a further rotation in market leadership. 

“Despite the challenging news flow from the first few mega-cap growth names that reported,” profit estimates for the 10 biggest S&P 500 stocks are being raised by a sharper degree than the rest of the index, Calvasina wrote in a note. “We’ve still not seen a clear shift in favor of small caps yet.”