U.S. equity strategist highlights three signs of slowing growth

Michael Wilson, a U.S. equity strategist at Morgan Stanley, sees equity returns for the remainder of 2022 as a race against time. In simple terms, the Federal Reserve needs to squash inflation before an economic slowdown forces corporate America to cut profit forecasts en masse.

Mr. Wilson identified three negative trends during the current quarterly earnings reporting season of the S&P 500 that suggest problems ahead for growth and earnings. First, consumers pinched by inflation are moving downscale, avoiding higher-end restaurants in favour of cheaper quick-service restaurants.

Second, the U.S. home renovation trend is slowing, a sign that rising interest rates are threatening a housing industry that accounts for almost 20 per cent of gross domestic product. Stanley Black & Decker Inc. has already cut full-year profit guidance and management at Best Buy Co. Inc. noted a slowdown in consumer electronics.

The third trend is bloated inventories. Walmart Inc. is the most prominent example of consumer companies that ordered inventory in anticipation of an accelerating postpandemic economy. Instead, a significant portion of these goods have gone unsold as consumer demand weakened.

These signs of slowing growth should be good for bond markets – lower growth expectations lead to lower bond yields, and bond prices climb. Indeed that was the case in July as the iShares Core U.S. Aggregate Bond ETF gained 2.5 per cent.

Equities also rallied in July, and Mr. Wilson is concerned this might be premature. The lower bond yields imply that fixed income investors believe the Fed will get inflation under control but “it may come with a heavier cost than normal, potentially a recession while they are still tightening, which may leave a very small window for stocks to work before earnings surprise on the downside,” he wrote.

Morgan Stanley expects that cuts to profit guidance will intensify in September and October this year as third-quarter earnings disappoint (thanks to weakening economic growth) and full year estimates can no longer be supported.

Equity markets are currently balanced between hopes that the peak in inflation pressure is behind us with consumer prices set to drop significantly, and fears that the tightening monetary policy that central banks used to tame inflation will cause a recession.

Tactically, I will be watching leading indicators of recession – like the steepness of the U.S. yield curve – while biding my time until market volatility during the fall months provides equity bargains.

A surge Friday in bond yields and drop in bond prices following much stronger than expected U.S. jobs data show just how treacherous it can be predicting the path forward.

Tactically, I will be watching leading indicators of recession – like the steepness of the U.S. yield curve – while biding my time until market volatility during the fall months provides equity bargains.