Stock Market Poised For Bigger Losses As Economy Enters ‘Danger Zone,’ Morgan Stanley Warns

Topline

The stock market broke a historic two-day rally on Wednesday as analysts warned it’s still too early to celebrate given a rash of looming risks—including incoming corporate reports that are likely to show just how badly deteriorating economic conditions are affecting company earnings.

“This is one of the most difficult macro forecasting environments most companies have ever … [+] encountered,” the investment bank’s strategists say.

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Key Facts

The Dow Jones Industrial Average fell nearly 200 points, or 0.6%, to 30,125 by 12:30 p.m. ET, paring a massive two-day gain of nearly 6%, while the S&P 500 and tech-heavy Nasdaq slumped 0.9% and 1.3%, respectively.

“The primary question on many investors’ minds has once again shifted to when the Federal Reserve pivots—not if,” Morgan Stanley strategist Michael Wilson wrote in a note, saying the economy has entered a “danger zone” in which Fed policy has become restrictive enough that financial and economic stress is bound to occur.

Wilson says “it’s only a matter of time” before a “fast and furious” market event convinces the Fed to back off on interest rate hikes, which help tame inflation by undercutting demand, but he cautions no one yet knows what type of event that will be.

Once the Fed reverses course, stocks and other risk assets (like cryptocurrencies) should rally again, but Wilson says it’s a “bad idea” to assume the gains will be long-lived because a slew of emerging risks—including economic weakness in Europe, the dollar’s strength and China reopening uncertainty—will likely hamper company earnings in the next two quarters.

In a Wednesday note, Wedbush analyst Dan Ives wrote that earnings over the next month will be “crucial” for technology giants in particular—either exposing the negative fundamentals and causing “massive” earnings cuts into next year or instead proving that many pockets of tech are holding up well despite the deteriorating economic conditions.

Morgan Stanley projects the S&P will ultimately hit a bear-market low of between 3,000 and 3,400 points—suggesting the index, which is already down 21.5% this year, could still plummet another 10% to 20%.

Crucial Quote

“It takes a long time for [earnings forecasts] to fall for the S&P 500 because it’s a very high quality, diversified index and companies are loath to throw in the towel on the future quarters until they have to,” says Wilson. “This is one of the most difficult macro forecasting environments most companies have ever encountered. It appears that more companies are reaching that point where they can’t fight it anymore.”

Key Background

Prolonged inflation has forced the Fed to hike interest rates more aggressively than previously expected this year, and stocks have suffered as a result. Despite rallying 5% this week as cooling labor market data suggested the economy may finally be slowing down enough to help inflation fall, some experts aren’t so sure the Fed has reason enough to act less hawkishly. “The economy is too strong for the Fed to pivot,” Oanda analyst Edward Moya said in a Wednesday note, pointing out that private-sector job data from payroll processor ADP showed there were a better-than-expected 208,000 new jobs added last month.

What We Don’t Know

The Fed is expected to raise rates by another 125 basis points this year, but that’s largely contingent on how incoming economic data measures up. Investors are hoping for worse-than-expected jobs data on Friday or better-than-expected inflation data later this month to help justify smaller hikes.

What To Watch For

Third-quarter earnings season kicks off next week, with big-bank earnings from Citigroup, JPMorgan and Morgan Stanley all slated for Friday, October 14.