'We Were Wrong:' Bearish Morgan Stanley Strategist Waves White Flag To Market Rally, But Points To Possible Headwind For 2nd Half

Morgan Stanley Equity Strategist Michael Wilson, who has been bearish on the market outlook, conceded that he was wrong amid the extended rally seen this year.

What Happened: Morgan Stanley's views on the broader U.S. equity market have been wrong this year, said Wilson in a note released on Monday.

Consumer spending has been better than expectations, Wilson said, delving into the reasons for his miscalculation. The stronger first-half spending, according to the analyst, was due to warmer weather, and consumers' willingness to borrow on credit cards. The analyst warned that these factors may not be sustainable in the second half.

The bank depositor program added about $400 billion to the Federal Reserve's balance sheet and this had supported asset prices, Wilson said. As the regional banking system becomes stable and the Fed's quantitative tightening ongoing, the analyst said the liquidity backdrop will likely become less constructive for equities, going forward, he said.

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The market also received a shot in the arm from artificial intelligence, with companies like Nvidia Corp. NVDA and Microsoft Corp. MSFT emerging clear winners, the analyst said. Taking cues from Taiwan Semiconductor Manufacturing Company Limited's TSM second-quarter results, the analyst said AI demand, though booming, can't offset fully the cyclical slowing that was being experienced across the broader semiconductor sector.

Another key driver of the U.S. equity market rally has been falling inflation, Wilson said. The upside market move based on this has gone further and persisted longer than Morgan Stanley expected, the analyst said.

“Last October, we based our tactically bullish call on the view that inflation was peaking along with back-end rates and the US Dollar. However, the upside move in equity multiples on the back of this theme (and the others discussed above) has gone further and persisted longer than we anticipated — i.e., we were wrong,” Wilson said.

Disinflation A Headwind? After falling inflation and cost-cutting led to higher-than-expected valuations, Morgan Stanley now sees disinflation eating into sales growth. “Investor focus is likely to shift toward topline growers rather than just companies exhibiting cost efficiencies,” it said.

The firm said it is pessimistic about 2023 earnings. While disinflation may be good from the monetary policy perspective, it poses a risk to nominal revenue and earnings. “We believe inflation is now falling even faster than consensus expects,” the firm said.

Wilson recommended stocks with high earnings quality, strong free cash flow generation and improving earnings revisions, driven by sales growth.

The analyst, however, continues to have a 2023 year-end S&P 500 price target of 3,900 compared to the 4,554.64 level at which it is trading now.

The SPDR S&P 500 ETF Trust SPY, an exchange-traded fund tracking the S&P 500 Index, ended Monday’s session at $454.20, up 0.45%, according to Benzinga Pro data.

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