Some analysts on Wall Street are very pessimistic. They say that signs that the economy will slow even more and pressure on the Federal Reserve to cut rates faster will make defensive stocks shine and small caps fade.
Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, said that the rising unemployment rate on Friday joins other signs of a weakening job market, such as the hiring rate, the payrolls survey, the Conference Board’s employment trends index, and the employment gauges on both the ISM manufacturing and services sector.
Wilson said, “For almost seven weeks, we have to wait for the next FOMC decision. We think the markets will challenge the Fed with lower yields and equity multiples, and maybe even wider credit spreads.”
On Monday, the 10-year Treasury yield BX:TMUBMUSD10Y dropped to 3.74%, while the S&P 500 futures ES00 -3.52% dropped almost 3%.
Wilson pointed out that the spread between 2-year and 10-year Treasurys has broken through resistance, which means the curve could get even steeper. This would be the first time in two years that the yield curve has not inverted. He says, “Bottom line, this recent steepening and rise in rate vol is probably one reason why stock volatility has picked up.”
The sharp turn around in small caps this past week shows that the move was more about positioning than anything else. Last week, the Russell 2000 RUT -3.52% fell 6.7%, and on Monday, Russell 2000 futures fell 4%.
We don’t think small caps will underperform large caps as much as they have over the past few years, but we still see the Russell 2000 going down in value because the economy is getting worse for consumers and workers and smaller cap stocks tend to be more sensitive to changes in the economy, he said.
Wilson says the micro data has been even worse, with some airline, restaurant, hotel, auto, and credit card companies missing earnings targets and lowering their guidance. The macro data has pointed to an end of the business cycle. “This difference is interesting because the micro data tend to be more forward-looking,” he said. “This is especially true for earnings revisions that are based on company guidance.”
The companies that are doing well are the ones that have strong revenue revisions. “We think this supports the idea that prices are generally going down as inflation goes down, and that companies that can keep their pricing power are generally getting rewarded,” he said.
Prices were 22 times earnings for the S&P 500 two weeks ago, and they are now 20.5. “These prices are likely to go down even more if earnings revisions keep going down the way seasonal patterns suggest they will.” “With our 12-month base case target multiple at 19x, the risk-reward for stocks is still generally not good,” he said.
Wilson said that this is the time of the cycle when the market usually rewards stable investments like utilities, healthcare, REITs, and food and drink.
