When Federal Reserve Chairman Jerome Powell made it clear on Friday that interest rates will continue to rise, the stock market reacted predictably with a big selloff, but there’s a bigger risk for stocks in the second half of 2022, according to Morgan Stanley strategist Michael Wilson.
Investors should pay attention to weak earnings, not rates, Wilson warned in an Aug. 29 note to clients. He said he believes “the path for stocks from here will be determined by earnings, where we still see material downside.”
The Fed is fully focused on lowering inflation to 2 percent, which should result in higher rates, Fed Chair Powell said Friday, Aug. 26 at the Kansas City Fed’s annual policy forum in Jackson Hole, Wyoming.
When interest rates rise, businesses and consumers cut back on spending. This causes earnings to fall and stock prices to drop.
The consumer price index (CPI) for July rose 8.5 percent, a slower pace than the 9.1 percent annual rise in June. It’s still the highest inflation in 40 years, but the slower pace helped send stock prices flying.
The Dow Jones Industrial Average plunged more than 1,000 points on Powell’s announcement, the tech-heavy Nasdaq composite lost almost 4 percent and shorter-term Treasury yields climbed as traders bet on the Fed staying aggressive with rates.
“Earnings are the bigger risk for stocks from here… Almost all of the weakness for stocks during 1H22 was due to the Fed and tighter financial conditions,” Wilson wrote. “The 2H outcome will ultimately be determined by earnings expectations for next year, in our view.”
While the Fed was to blame for “almost all of the weakness” in the first half of the year, Wilson said that the second half of 2022 will be marked by earnings expectations for 2023.
“Equity investors should be laser focused on this risk, not the Fed, particularly as we enter the seasonally weakest time of the year for earnings revisions, and inflation further eats into margins and demand,” Wilson said.
Morgan Stanley’s leading earnings model sees a steep fall in earnings per share (EPS) growth over the next several months, Wilson wrote.
“A key input to this model is the ISM manufacturing PMI, and leading regional Fed manufacturing surveys point to continued downside in the ISM PMI. The rate of change on earnings revisions breadth also leads forward EPS growth and points to growth downside as well.”
The ISM (Institute for Supply Management) manufacturing index or purchasing managers’ index (PMI) is considered a key indicator of the state of the U.S. economy. It indicates the level of demand for products by measuring the amount of ordering activity at U.S. factories.
Retail giants including Walmart, Target and Best Buy say they are marking down excess inventory and canceling orders, Fortune reported.
Retailers’ earnings show that lower and middle-income consumers have been hit hardest by rising prices, said Ted Rossman, a senior industry analyst at Bankrate. In its second-quarter earnings release, Macy’s said that it is seeing higher-income consumers continuing to spend while lower and middle-income consumers are making big changes in how they spend.
Real average hourly earnings — wages adjusted for inflation — fell 3 percent year-over-year in July, according to an Aug. 10 Bureau of Labor Statistics report.