Morgan Stanley with a note that I largely agree with:
Our discussions with clients are narrowing to two primary topics: Earnings and Inflation. On the former, we hear many saying earnings estimates are still too low. On the latter, the focus has become an obsession. On both fronts, we could beat a moment of (too) Great Expectations.
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It’s better to travel that arrive. Markets are discounting machines and often anticipate changing dynamics long before they become obvious. However, eventually such changes do become obvious and priced, at which point are set is required or evidence the higher expectations are not only achievable, but beatable. Our V-shaped recovery call is now the consensus and bottom-up 2022EPS estimates are now ahead of our top forecasts for the first time since the recovery began.
Earnings revisions have peaked, which usually means lower P/Es. Much of our mid-cycle transition call is based on the arrival of the peak rate of change in both growth and policy. Bear in mind, this does not mean negative growth or revision but a deceleration. The adjustment for markets means lower valuations, a process that began in 1Q for the most expensive stocks.
We think that de-rating will now broaden out, which means investors must find stocks where expectations can still rise more than P/Es fall, or about 15%, in our view. Inflation expectations have also increased beyond what may be achievable in the near term. Inflation is on the upswing in our view and will eventually surpass the Fed’s targets on a sustainable basis. However, expectations have increased too and now price this rise in many asset markets. With May’s CPI release much anticipated on June 10th, we suspect this could end up being sell the news event that could negatively affect many crowded trades.
Continue to favor defensive and reasonably priced Quality during the mid-cycle transition. During this period, valuations for the S&P500 typically adjust lower by approximately 20%. WithP/Es down only 5%, we think another 15% is to come. We think superior execution during the reopening phase and earnings stability are traits the market will reward. That argues for leaning back into quality stocks; however, one must still be disciplined on the price paid. Today, we present our updated screens for stocks that should weather the de-rating best. Candidates can be found across many sectors; however, we recommend skewing a bit more defensively than most are currently positioned.
I am still very bullish on earnings so my base case is still steady as she goes.
But my risk case of convergence between a slowing China and slowing US in Q4 is growing and I am fully expecting a commodities bust to begin sometime over the next six months.
So, that could be the trigger for a wider equity correction if it drags in junk debt and EMs with a rising DXY.