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Morgan Stanley sees growing risk of 'earnings recession' next year as yield curve inverts

Key Points
  • Morgan Stanley says that inversion of the so-called yield curve "supports our late cycle view and growing risk of an earnings, if not economic, recession next year."
  • Chief equity strategist Michael Wilson adds that he wasn't surprised to see Wall Street's major indexes swoon in response to the shift in rates last week.
  • Wilson warned of dismal results in equities throughout 2018 and said the market could be paralyzed in a "rolling bear market" for the next several years.
Traders work on the floor of the New York Stock Exchange.
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Inversion of the so-called yield curve is yet another reason to fear an earnings, or even an economic, recession in 2019, according to Morgan Stanley.

The bank's chief U.S. equity strategist told clients that while it's difficult to forecast what an inverted yield curve means for stocks in the near term, he wasn't surprised to see Wall Street's major indexes swoon in response to the shift in rates.

"Yield curve inversion was inevitable after five years of flattening. Unfortunately, it is not a clear signal for what happens next," equity chief Michael Wilson wrote. "More importantly, we think it supports our late cycle view and growing risk of an earnings, if not economic, recession next year."

Wilson sees a 50 percent chance of an earnings recession in 2019, but said it could take time for the market to price a contraction until it has more "hard evidence."

An economic recession, such as the one that occurred in the aftermath of the 2008 financial crisis, is defined as two consecutive quarters of negative GDP growth. An earnings recession, on the other hand, is often defined as two consecutive quarters during which S&P 500 earnings decline on a year-over-year basis.

An inverted yield curve is often considered a sign of future economic recession as investors bet returns over the short term will exceed those over several years. Portions of the yield curve, which first inverted earlier this month, remained downward sloping Monday with short-term 2-year Treasury note yields above 5-year Treasury note yields. Yields fall when bond prices rise.

The 2-year note yield was last seen at 2.705 percent while the 5-year note yield slipped to 2.694 percent. The closely followed spread between the 2-year Treasury note yield and the 10-year Treasury note yield remains positive, though flattening at around 13 basis points. The 2-10 spread is the curve that the plurality — if not the majority — of money managers use when deciding whether the curve is inverted.

Wilson warned of dismal results in equities throughout 2018 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.

The fell 0.3 percent Monday, adding to a 1.8 percent decline in 2018. The broad market index is down 5.8 percent over the past week, since the yield curve first inverted last Monday.

"Our work shows that post yield curve inversion the equity market can move higher, but the evidence is hardly compelling or consistent," Wilson added. "More importantly, we think making such a statement absolutely is misleading and misses the more important point for investors."

Morgan Stanley conducted its own research on the yield curve and found that inversion is neither bullish nor bearish and "far from conclusive either way." In past cycles, Wilson said, the yield curve has often inverted twice before an economic recession.

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.