Investors flocking to the equity rally will be disappointed as they’re in direct defiance of the Federal Reserve, according to Morgan Stanley strategists.
“Better price action in stocks has started to convince many investors they are missing something — compelling them to participate more actively,” a team led by Michael Wilson wrote in a note. “We think the recent price action is more a reflection of the seasonal January effect and short covering after a tough end to December and a brutal year.”
In reality, earnings are worse than expected, especially on the margins front, they said. “Secondly, investors seem to have forgotten the cardinal rule of ‘Don’t Fight the Fed.’ Perhaps this week will serve as a reminder.”
Officials at the US central bank are poised to raise their benchmark federal funds rate by a quarter percentage point on Wednesday, dialing back the size of the increase for a second-straight meeting. The move would follow a slew of recent data suggesting the Fed’s aggressive campaign to slow inflation is working.
The S&P 500 has rallied since the earnings season started, extending the new year’s advance. Even as signs of a slowdown mount, investors are rewarding companies that exceed expectations and dialing back the punishment of those that fall short. Bloomberg Intelligence’s Wendy Soong attributed that dynamic to restructuring efforts and cost-cutting plans creating more confidence among investors.
Yet, a Fed that’s unwilling to pivot to a more dovish stance “coupled with the reality of the worst earnings recession since 2008 is being mispriced once again, in our view,” Wilson said. “We think this should lead to the final leg of this bear market in short order.”
Strategists at JPMorgan Chase & Co. also said investors should sell the rally even if markets keep moving higher. Fundamental confirmation for the next leg higher might not come, and weaker earnings as well as activity could weigh on equities, a team led by Mislav Matejka wrote in a separate note on Monday.
Last week, the bank’s chief global markets strategist and co-head of global research, Marko Kolanovic, said the economy is headed for a downturn at a time stocks are rallying, setting the stage for a selloff. He expects a recession in the US and Europe, as interest rates rise and consumers become less resilient, he said.
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