Don't expect stocks to rebound if inflation anxiety continues, according to Morgan Stanley.
With price fears egging on Treasury rates, equities could be in for a disappointing few months as investors move away from a "buy-the-dip" mentality.
"When inflation is very low, rising inflation has a positive impact on equity valuations," wrote Mike Wilson, chief investment officer at Morgan Stanley. But "rising inflation expectation may no longer be a positive for stocks, especially if markets start to think inflation is coming 'unhinged.'"
Stocks are in the middle of a sizable sell-off with the Dow Jones industrial average falling more than 450 points Monday, adding to a 3.5 percent decline the previous week. The S&P 500 fell 1.6 percent on the week's first day of trade, as the Cboe volatility index (VIX) — considered the market's best fear gauge — hit multi-year highs.
Many strategists have hypothesized that the sell-off is the result of several months of uninterrupted gains for equity markets, a correction to overpriced stocks and inflated assets. And with the yield on the 10-year Treasury note climbing roughly 40 basis points since the start of the year, investors may be in for a bumpy ride.
For his part, Wilson is the single most bearish strategist on Wall Street, with a year-end S&P 500 target of 2,750, just 1 percent above its current level. He believes it may be time to shift equity exposure toward defensive stocks and away from cyclical sectors like technology.
Cyclical stock performance tends to follow the health of the overall economy, while defensive stock performance is generally resistant to external pressures.
"Technology does not look very good. In fact, it looks downright awful," Wilson warned in his Monday note. "We noticed the bond proxies —Telecom, Utilities and Staples--were all significantly underperforming recent revisions which led us to write a note two weeks ago suggesting these sectors could snap back."
Indeed, he added, that has happened with the cyclicals underperforming defensives by approximately 5 percent despite the fact that interest rates have continued to rise.
Wilson downgraded the technology sector to equal-weight from overweight and highlighted weaker performance in semiconductor and software companies.
Chipmakers were some of the best-performing stocks in 2017, with names like Broadcom and Micron posting gains of 17 percent and 66 percent respectively over the past 12 months. But 2018 has proven to be more turbulent for the tech companies, with Broadcom and Micron down 11 percent each over the past month.
Wilson added that software and services companies like PayPal, Google-parent Alphabet and Activision Blizzard have also been lackluster in the past few weeks.
But Wilson's thesis did favor some sectors.
He upgraded the utilities sector to overweight, arguing that the recent uptick in yields is unlikely to last. Utilities stocks, traditionally viewed as bond proxies, could see upside if Treasury yields recede from their recent highs.
"We are not believers in the sustainability of the level of yields," Wilson explained. "As one of the most rate-sensitive equity sectors, and one that has certainly moved down as rates have risen, we recommend going overweight utilities to play a rate retracement at some point in the not too distant future."
But if rates maintain their upward momentum, utilities can still find support in a recovery in earnings revisions, according to Wilson. Utilities largely outperformed last week despite the rise in rates, posting a loss of 0.6 percent over the past week versus the S&P 500's loss of 3.8 percent.