Morgan Stanley's equity strategist who foresaw the recent sell-off in U.S. stocks sees a lackluster year ahead, marred by underwhelming corporate earnings and tougher financial conditions.
Mike Wilson, chief equity strategist at Morgan Stanley, said in a note that he "sees more of the same" stagnant performance from the major indexes in 2019 and forecasts the S&P 500 finishes next year at 2,750, just 3 percent above current levels. His 2019 target is the equivalent to his 2018 target, implying no growth over 12 months.
"After a roller coaster ride in 2018 driven by tighter financial conditions and peaking growth, we expect another range-bound year driven by disappointing earnings and a Fed that pauses," Wilson wrote in a note to clients Monday. "We think there is a greater than 50 percent chance we experience a modest earnings recession in 2019 defined as two quarters of negative year-over-year growth for S&P 500 EPS."
Wilson has repeatedly warned of dismal results in equities this year and said the market could be paralyzed in a "rolling bear market" for the next several years with the S&P 500 trading in a range of 2,400 to 3,000. The strategist was the most bullish in 2017, when the market posted a strong rally; he has called for flat performance throughout 2018 and has been validated through Friday's close.
The S&P 500 finished 2017 at 2,673.61, within 30 points of Wilson's 2,700 target; the index is down 0.15 percent in 2018.
Wilson said a contraction in earnings growth shapes much of his view on the year ahead.
"The recent strong run of growth we have seen in earnings may have lulled the market into complacency on the forward outlook, but with decelerating topline and building cost pressures, we are highly confident that earnings growth will be below consensus expectations next year and believe there is elevated risk of an outright earnings recession," he wrote.
Among the several reasons Wilson cited as reasons to expect a slowdown in earnings growth is decelerating gross domestic product growth as the effects of President Donald Trump's tax cuts wear off and interest rates continue their upward climb. Morgan Stanley's economists forecast real fourth-quarter GDP growth slowing from 3.1 percent in 2018 to 1.7 percent in 2019 on a year-over-year basis.
Such a large deceleration in U.S. GDP will ripple throughout the economy and weigh on corporate sales growth, the biggest contributor to earnings growth, Wilson said.
"Sales growth is much more sensitive to GDP growth as GDP growth is decelerating, which is exactly the environment we expect to be in next year. This makes sense as it is not hard to understand how companies spend more money when growth is accelerating. Such spending represents revenue to someone else," he wrote. "Conversely, if GDP growth is decelerating, that circle can turn from virtuous to vicious, especially when it is decelerating rapidly."
Combined with tighter financial conditions as imposed by the Federal Reserve, the downshift in topline growth will force discipline on investors who can no longer afford to overpay for financial assets with long duration, the strategist added. As such, Wilson reiterated his preference for value stocks over growth stocks, upgrading consumer staples to overweight and bumping REITs up to equal weight.
Recent economic data — including strong GDP prints — have prompted Fed's policy-making arm to defend its three increases to the overnight rate this year. Both the Fed and markets anticipate a fourth rate hike in December.
Wilson is also overweight financial, energy and utilities stocks; he's underweight consumer discretionary and technology. Though energy stocks have underperformed the S&P 500 this quarter thanks to a dive in oil prices, financials, consumer staples and utilities have bested the market.
The Financial Select Sector SPDR Fund is down 3.7 percent since Sept. 30, while the Consumer Staples Select Sector SPDR Fund is up 1.5 percent. The utilities ETF is up 2.6 percent over the same period.
"The bottom line is that investors need to pay more attention to valuation now, especially for over-loved growth stories that are effectively the longest duration assets in the world," he added. " This can also apply to Value stocks as well which means stock selection will prove to be more important than style or sector preferences."