Typical Mid-Cycle Correction Would Yield 10% Correction in S&P500, But a 'More Destructive Outcome' is Starting to Look More Likely - Morgan Stanley

September 20, 2021 7:02 AM EDT
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Michael Wilson, the Chief U.S. Equity Strategist and Chief Investment Officer at Morgan Stanley, believes Wall Street is leaning towards a broader market correction that could yield a bigger-than-anticipated pullback.

Typically, the mid-cycle transition would end with a “rolling correction” that ultimately hits S&P 500, writes Wilson in a note sent to clients. He sees two short-term risk paths that would yield a correction: 1) fire (overheating economy) and 2) ice (earnings revisions and data points deceleration).

Morgan Stanley’s year-end price target on S&P 500 is about 10% lower compared to the current index price.

“The typical mid-cycle "fire" outcome would lead to a modest and healthy 10% correction in the S&P 500. However, the "ice" scenario is starting to look more likely, and could result in a more destructive outcome – i.e. a 20%+ correction. As a result, we continue to recommend a barbell of more defensively oriented quality (Healthcare and Staples) to protect from the "ice" scenario while keeping a leg in Financials to participate in the "fire" outcome as higher rates materialize. On the decelerating growth ("ice") front, we point to downside risk to earnings revisions, consumer confidence and PMIs. These indicators are all highly correlated to S&P price on a rate of change basis, and thus we highlight what downside in these measures could mean for the S&P 500,” Wilson said in a client note.

Wilson reiterates his previous stance that investors are better off holding services over goods in the discretionary sector, with the former holding “only” 17% of the sector’s market cap. Moreover, the strategist recommends defensively oriented quality sectors, likely healthcare and staples, while also recommending exposure to Financials in case rates move higher as well.

“Given the overconsumption that’s already taken place within consumer goods and the fact that pricing is becoming demand destructive, we're wary of the Discretionary sector's heavy weight toward goods and remain underweight the sector. From an economic standpoint, the dynamic is different, as personal consumption is driven by services more so than goods. Thus, a reversion in goods personal consumption back to trend is less of an economic risk than a market one,” Wilson adds.

S&P 500 futures are down 1.3% today.

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