The last time corporate profits plunged into a recession, stocks kept rallying — but Morgan Stanley says there are now 8 big differences that could send the market tumbling

By: Business Insider

March 19, 2019 at 05:58 AM EDT

Scott Olson/Getty

Mike Wilson, the chief US equity strategist at Morgan Stanley, has been calling for a corporate earnings recession all year.
While stocks stayed resilient during the last S&P 500 earnings recession in 2016, Wilson lays out several key differences between that situation and the current one.
Wilson concludes that conditions are far less favorable this time around, and warns investors to be careful going forward.

Mike Wilson, the chief US equity strategist at Morgan Stanley, has been warning about an earnings recession all year.

His forecast stands in contrast to the rest of Wall Street, which has a consensus profit-growth estimate of 5.1%. Wilson says that optimism — as well as the confidence being exhibited by investors themselves — is being fueled by a flawed comparison to an earnings recession that occurred several years ago.

From the second quarter of 2015 through the second quarter of 2016, S&P 500 earnings slipped into negative territory. And while investors certainly faced a handful of brief downturns, the end result was surprising: The market ultimately rose across the entire period.

Based on that ultimately positive result, it's easy to see why investors don't seem worried about a prolonged period of profit contraction. But Wilson says that kind of gain is unlikely this time around.

Many of Wilson's reasons center around the idea that, unlike three or four years ago, there may not be enough economic growth to get stocks out of the hole. As a result, he recommends market participants seek out protection.

"Fundamentally we retain a defensive bias and think that stock/sector selection are more fertile grounds for returns," Wilson said.

Here are the eight main differences he sees leading stocks — and earnings expansion — towards a dim future.

1) There's less Chinese stimulus

China's government is trying to pump up its economy, something it also did in 2015-16. But Wilson says the present-day stimulus measures are significantly smaller, and their effects on credit conditions will be, too. This chart shows compares China's latest stimulus moves to some past efforts:

2) Fed tightening is much further along

The Federal Reserve raised interest rates in December 2015, the first hike in almost a decade. But after the market had a brutal start to 2016, it held off on raising rates for a time, which contributed to the rally in 2016. A similar pattern has emerged since the Fed said it would be "patient" in raising rates this year.

The difference is that — in between the two instances — the Fed raised rates an additional eight times, and has allowed its balance sheet to shrink. That's tightened financial conditions and put a brake on growth this time around.

3) The current US GDP output gap is much more late-cycle

Wilson says the US economy wasn't growing at its full potential in early 2016. That's based on a measurement called GDP output gap, or the difference between actual and potential gross domestic product. A gap can be a sign of a sluggish economy and labor market.

But today, Wilson says, the economy is growing above its long-term potential — meaning there isn't much room for improvement that would boost earnings and stock prices. It's also a sign the US is later in its economic cycle, meaning a recession is closer at hand.

4) A much tighter labor market

The unemployment rate has dropped to its lowest level in decades, which is putting upward pressure on wages. Wilson says executives are growing more concerned about labor costs, as higher pay erodes companies' profit margins and can affect stock prices.

That stands in contrast to 2016, when there was far more slack in the labor market.

5) Tougher year-over-year profit growth comparisons

Company profits and sales climbed in 2017 and got another boost last year from the Tax Cuts and Jobs Act. As a result, Wilson says that — on a year-over-year basis — any future earnings growth will look fairly uninspired in comparison. And that will leave investors relatively unenthusiastic about stocks.

"It is hard to outgrow GDP as earnings have done for the past two years without some payback," he said.

In the chart below, he notes that even though Wall Street consensus earnings growth is expected to be positive for 2019 and 2020, that will be subdued compared to prior years.

6) A bigger inventory build

Wilson says US companies stockpiled inventory last year in response to faster economic growth. Some importers were also trying to beat the rising tariffs that resulted from the US's trade war with China. The inventories that have built up are driving down prices and sales today, and Wilson thinks the effect is likely to endure for some time.

Wilson notes that, back in 2016, the inventory surplus was much more advanced. This can be seen in the chart below.

7) The capital spending cycle is in a boom phase this time

Wilson argues that past fiscal stimulus and the 2017 tax cuts pushed companies to ramp up their capital spending the last few years. They probably won't do that again, and he expects that to limit potential growth in earnings and the broader economy.

Compare that to 2016, when companies were fresh off a capital-spending low. The difference is shown in the chart below.

8) Valuations are less forgiving now

There's far less room for error when it comes to stock valuations, Wilson says. That's because, back in 2016, the market was underpinned by more optimistic prospects for global growth.

The chart below shows a measure called the equity risk premium, which is defined as the excess return with which investors are compensated for taking on more risk. As you can see, we're starting at a far lower level now, which implies just how unforgiving valuations are now, compared to 2016.

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