Investing.com -- “The sharp correction in stocks in July/early August was due to several factors, with the most important one being softer-than-expected economic growth data that culminated in a weak employment report on August 2”, said analysts at Morgan Stanley (NYSE:MS) in a note.
The upcoming release of the August jobs report on September 6 is expected to play a vital role in determining whether the market's recent rebound can continue or if renewed worries about economic growth will lead to further downward pressure on stock valuations.
Morgan Stanley analysts forecast that this report will significantly influence the market's future trajectory.
The market downturn earlier this summer was primarily triggered by a series of disappointing economic indicators, culminating in a weak employment report on August 2.
The most important factor was a 0.2 percentage point increase in the unemployment rate, which activated the Sahm Rule—a key recession indicator—and heightened fears of a potential hard landing for the economy. This spooked investors, leading to a broad-based sell-off in equities.
While some positive economic data, including better-than-expected jobless claims, retail sales, and the ISM non-manufacturing survey, have since emerged, the recovery in equity markets has been uneven.
Many indices have rallied back near all-time highs, yet the bond market, the yen, and commodities suggest lingering caution among investors. Furthermore, equity market "internals," such as the performance of cyclical versus defensive stocks, have not rebounded significantly, indicating a cautious market sentiment.
Morgan Stanley analysts say that the August jobs report will be a critical test for the market's recovery. “A stronger-than-expected payroll number and lower unemployment rate would likely provide markets with greater confidence that growth risks have subsided, paving the way for equity valuations to remain elevated and a potential catch-up in some other markets/stocks that have lagged,” the analysts said.
Conversely, another weak jobs report, particularly if it shows a further rise in the unemployment rate, could reignite fears of a hard landing and put renewed pressure on equity valuations.
Morgan Stanley's economists are forecasting a non-farm payroll increase of 185,000 jobs and a decrease in the unemployment rate to 4.2%, which aligns with market consensus. However, they caution that the stakes are high, given the market's current valuation levels.
Morgan Stanley flags the challenge for equity investors in the current environment. The S&P 500 is trading at 21 times earnings, which places it in the top decile of its historical valuation range. This is based on consensus earnings per share (EPS) growth estimates of 11% for this year and 15% for next year—well above the longer-term average of 7%.
Given these elevated valuations and high earnings expectations, Morgan Stanley sees limited upside at the index level over the next 6-12 months, particularly in a soft-landing scenario, which is their base case.
The market's current valuation levels make it vulnerable to a downturn in case of a hard landing. The upcoming labor report is crucial as it could either strengthen or weaken the current market sentiment.
Morgan Stanley also notes that the Bloomberg Economic Surprise Index, which tracks the degree to which economic data exceeds or falls short of expectations, has not yet reversed its downward trend that began in April.
Additionally, cyclical stocks continue to underperform relative to defensive stocks, further suggesting that growth concerns remain prevalent.
Unlike previous corrections in 2022 and early 2023, where inflation was the primary risk, the current market dynamics are driven by growth worries.
This shift supports the idea that, until there is clearer evidence of improving economic growth, investors should favor high-quality defensive stocks in their portfolios.
Analysts believe that AI stocks have been a major force in the U.S. market, but recent disappointing earnings have caused a decline in many of these stocks.
While Morgan Stanley doesn't think the AI trend is over, they suggest investors might be looking for a new market theme that can attract a lot of investment.
In this context, the analysts advise against rotating into small-cap or other cheap cyclical stocks that have underperformed in recent years. They argue that in a late-cycle, soft-landing scenario where the Federal Reserve is cutting rates, these areas of the market typically do not perform well.
Morgan Stanley flags that the bond market has already expected some of the Federal Reserve’s potential interest rate cuts. With back-end rates falling by more than 100bp over the past 10 months, making borrowing cheaper for things like mortgages. Despite this, sectors highly sensitive to interest rates, such as housing, car purchases, and credit card spending, haven't seen a boost yet.
This lack of response from the cyclical parts of the equity market further supports the analysts' cautious outlook. Unless the Fed cuts rates more than the market is currently expecting, the economy strengthens, or additional policy stimulus is introduced, Morgan Stanley expects minimal returns at the index level over the next 6-12 months.