Equity Investment in 2023

For the first half of the year, U.S. stocks and bonds moved in pretty much the same direction, as Federal Reserve policy tightening drove bear-market declines in both asset classes.

But since then, stocks and bonds have taken somewhat different paths:

• Treasury yields have continued to surge, driving bond prices lower. Also, the yield curve has grown more deeply inverted, signaling expectations of economic slowing ahead.

• Stock investors, meanwhile, seem optimistic. They point to stocks’ resilience into year-end and believe the Fed can slow growth enough to tame inflation without triggering a recession and that corporate profits will remain relatively unscathed. Their optimism is reflected in consensus 2023 corporate earnings estimates for the S&P 500 Index at $230 per share.

Morgan Stanley’s Global Investment Committee disagrees. We expect corporate sales volumes and pricing power to deteriorate, leading to profit declines, even without a recession, hence our lower earnings estimate of $195 per share for 2023. When we consider factors such as the Purchasing Managers’ Index (PMI) data, the yield curve and correlations between profit growth and the speed of the Fed’s rate hikes, we anticipate that 2023 year-over-year earnings growth will likely be materially negative.

But could we be wrong? Here are two scenarios to consider:

• Scenario 1: Corporate cost-cutting works so well that it offsets declines in revenues. Some technology companies have made job cuts that seem to suggest they can manage costs ahead of any weakening in sales, which would help preserve profits in the short term. However, systemic layoffs may be a double-edged sword. Rising unemployment constrains consumer spending—a key driver of economic growth—and risks a “hard landing” for the economy overall.

• Scenario 2: The strength of the labor market and consumer spending helps sustain 2023 corporate profits. Optimistic investors think continued labor-market tightness, wage gains and resilience in personal spending are reasons to be sanguine about 2023 corporate profits. However, if U.S. growth proves stronger, inflation would likely come down more slowly. This could create incentives for the Fed to push rates higher—and keep them higher for longer—to more forcefully slow the economy and rein in price growth.

These scenarios are possible, but we still don't view them as likely. There is currently a good deal of uncertainty around earnings and valuations, and for now we prefer to keep our focus on income.

Investors should consider selling certain holdings, such as passive U.S. stock indices, at a loss before year-end to potentially reap the benefits of tax-loss harvesting. They may wish to re-invest the proceeds into yield-producing assets, such as Treasuries, municipal bonds, corporate credit and master limited partnerships (MLPs). High-dividend and value-oriented equities and residential real estate investment trusts (REITs) could also make sense.

Source: Morgan Stanley