by Michael Wilson, Equity Strategist, Morgan Stanley
Highlights:
Our discussions with clients are narrowing to two primary topics: Earnings and Inflation. On the former, we hear many saying earnings estimates are still too low. On the latter, the focus has become an obsession. On both fronts, we could be at a moment of (too) Great Expectations.
• It's better to travel than arrive. Markets are discounting machines and often anticipate changing dynamics long before they become obvious. However, eventually such changes do become obvious and priced, at which point a reset is required or evidence the higher expectations are not only achievable, but beatable. Our V-shaped recovery call is now the consensus and bottom-up 2022 EPS estimates are now ahead of our top forecasts for the first time since the recovery began.
• Earnings revisions have peaked, which usually means lower P/Es. Much of our mid-cycle transition call is based on the arrival of the peak rate of change in both growth and policy. Bear in mind, this does not mean negative growth or revision but a deceleration. The adjustment for markets means lower valuations, a process that began in 1Q for the most expensive stocks. We think that de-rating will now broaden out, which means investors must find stocks where expectations can still rise more than P/Es fall, or about 15%, in our view.
• Inflation expectations have also increased beyond what may be achievable in the near term. Inflation is on the upswing in our view and will eventually surpass the Fed's targets on a sustainable basis. However, expectations have increased too and now price this rise in many asset markets. With May's CPI release much anticipated on June 10th, we suspect this could end up being a sell the news event that could negatively affect many crowded trades.
• Continue to favor defensive and reasonably priced Quality during the mid cycle transition. During this period, valuations for the S&P 500 typically adjust lower by approximately 20%. With P/Es down only 5%, we think another 15% is to come. We think superior execution during the reopening phase and earnings stability are traits the market will reward. That argues for leaning back into quality stocks; however, one must still be disciplined on the price paid. Today, we present our updated screens for stocks that should weather the de-rating best. Candidates can be found across many sectors; however, we recommend skewing a bit more defensively than most are currently positioned.
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