Morgan Stanley: Best Part Of The U.S. Rally Is Over

Morgan Stanley equity strategist Wilson notes “we agree with the view that inflation has peaked. In fact, inflation expectations crested in April and are down considerably for all tenors. However, the equity risk premium is back to just 285bp (fair value is closer to 400bp in our model). With 10-year yields already down considerably, it’s hard to argue for higher valuations with earnings estimates and PMIs falling. Therefore, the question equity investors should really be asking now is whether falling inflation will be good or bad for profits. Our view is that falling inflation will essentially have the exact opposite effect on profits that rising inflation did in 2020-21, and the consensus is underestimating the negative operating leverage cycle that has just begun, much as it underestimated the positive operating leverage as inflation rose. The only question is by how much? Meanwhile, the strong labor report on Friday suggests companies have yet to cut labor in an effort to protect margins while simultaneously delaying any Fed pivot. In short, inflation is likely to fall from here. While that may be good for bonds and valuations, it won't be good for profits – i.e., be careful what you wish for. The rally in stocks has been powerful and has investors believing the bear market is over and looking forward to better times. However, we think it’s premature to sound the all-clear simply because inflation has peaked. The next leg lower may have to wait until September when our negative operating leverage thesis is better reflected in earnings estimates. However, with valuations this stretched, we think the best part of the rally is over.”