Market Analysis

The stock market's sharp decline in July and early August was influenced by several factors, with the most significant being weaker-than-expected economic growth data, culminating in a disappointing employment report on August 2, according to Morgan Stanley analysts.

The upcoming August jobs report, scheduled for release on September 6, is anticipated to be crucial in determining whether the market's recent rebound can be sustained or if renewed economic growth concerns will exert additional downward pressure on stock valuations. Morgan Stanley analysts predict that this report will have a major impact on the market's future direction.

The earlier summer market downturn was primarily triggered by a series of lackluster economic indicators, culminating in the weak employment report on August 2. A key factor was a 0.2 percentage point increase in the unemployment rate, which activated the Sahm Rule—a significant recession signal—and heightened fears of a severe economic slowdown. This prompted a broad-based sell-off in equities.

Although there have been some positive economic reports since, including better-than-expected jobless claims, retail sales, and the ISM non-manufacturing survey, the recovery in equity markets has been uneven. Many indices have approached all-time highs, yet the bond market, the yen, and commodities suggest ongoing investor caution. Additionally, equity market internals, such as the performance of cyclical versus defensive stocks, have not shown significant improvement, reflecting a cautious market sentiment.

Morgan Stanley analysts view the August jobs report as a critical test for the market's recovery. “A stronger-than-expected payroll number and a lower unemployment rate would likely boost market confidence that growth risks have diminished, potentially allowing equity valuations to remain high and leading to a catch-up in lagging markets and stocks,” the analysts stated.

Conversely, another weak jobs report, especially if it shows a further rise in the unemployment rate, could revive fears of a severe economic downturn and put additional pressure on equity valuations.

Morgan Stanley's economists are predicting a non-farm payroll increase of 185,000 jobs and a decrease in the unemployment rate to 4.2%, aligning with market expectations. However, they caution that the stakes are high given the current market valuation levels.

Morgan Stanley highlights the challenge for equity investors in the current environment, noting that the S&P 500 is trading at 21 times earnings, placing it in the top decile of its historical valuation range. This valuation is based on consensus earnings per share (EPS) growth estimates of 11% for this year and 15% for next year, which are significantly above the long-term average of 7%.

Given these high valuations and earnings expectations, Morgan Stanley sees limited upside potential for the index over the next 6-12 months, particularly under a soft-landing scenario, which is their base case.

Current market valuation levels make it susceptible to a downturn in the event of a severe economic slowdown. The upcoming labor report is pivotal, as it could either strengthen or weaken current market sentiment.

Morgan Stanley also notes that the Bloomberg Economic Surprise Index, which tracks the extent to which economic data exceeds or falls short of expectations, has not yet reversed its downward trend that began in April. Furthermore, cyclical stocks continue to lag behind defensive stocks, indicating persistent growth concerns.

Unlike previous corrections in 2022 and early 2023, which were driven primarily by inflation risks, the current market dynamics are more influenced by growth concerns. This suggests that until there is clearer evidence of improving economic growth, investors might benefit from favoring high-quality defensive stocks.

Analysts observe that AI stocks have been a significant driver in the U.S. market, but recent disappointing earnings have led to declines in many of these stocks. While Morgan Stanley does not believe the AI trend is over, they suggest that investors may be seeking new market themes to attract investment.

In this environment, Morgan Stanley advises against rotating into small-cap or other undervalued cyclical stocks that have underperformed in recent years. They argue that in a late-cycle, soft-landing scenario with potential Federal Reserve rate cuts, these areas of the market typically perform poorly.

Morgan Stanley points out that the bond market has already priced in some potential Federal Reserve interest rate cuts, with back-end rates falling by more than 100 basis points over the past 10 months, making borrowing cheaper. Despite this, sectors highly sensitive to interest rates, such as housing, car purchases, and credit card spending, have yet to see significant improvements.

This lack of response from cyclical parts of the equity market reinforces the analysts' cautious outlook. Unless the Fed cuts rates more than currently anticipated, the economy strengthens, or additional policy stimulus is introduced, Morgan Stanley expects minimal returns at the index level over the next 6-12 months.

Paraphrasing text from "Investing" all rights reserved by the original author.