Morgan Stanley's 2023 equity strategist says the Fed's 8th rate hike likely to fade

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Morgan Stanley's 2023 equity strategist says the Fed's 8th rate hike likely to fade

A surprisingly good start for the US stock market in 2023 is likely to fade this week as the Federal ReserveFederal Reserve is poised to announce its eighth consecutive rate hike at the end of its policy meeting, according to Morgan Stanley spokesman Michael Wilson.

The recent price action is more reflective of the seasonal January effect and short covering after a tough end to December and a brutal year, wrote a team of strategists led by Wilson, Morgan Stanley's chief equity strategist. Earnings are worse than feared based on the data, especially as it relates to margins. In January, stock market investors were on a high note, with three major equity indexes on pace to book strong monthly gains. The S&P 500 SPX was up 5.5% in the first four weeks of January, while the Dow Jones Industrial Average DJIA went up 2%. Tech stocks had their best January in decades, with the Nasdaq Composite COMP, up 9.2%, on Monday, on track for its best January performance since it posted a 12.2% gain in 2001, according to Dow Jones Market Data.

Wilson and his team were surprised by the magnitude of the recent advance. It is just another bear-market trap and all the good news is now priced, which means the reality is likely to return with month-end, and the Fed s resolve to tame inflation, they wrote in a Monday note.

See What Stock Market investors need to know about the January Indicator Trifecta. The January Effect is a seasonal tendency for small-cap stocks to rally in the month following December's tax-loss harvesting in generally illiquid equities. Other possible explanations include window dressing, a practice performed by institutional investors to buy more shares of top performing stocks by the end of the year to improve the appearance of their fund's performance before presenting it to shareholders.

As the new year begins, investor sentiment tends to be more optimistic about the future.

Morgan Stanley s strategists warned at the beginning of the year that a recession shock in 2023 could cause another 22% drop in stocks, and they expect the large-cap index to finish the year at 3,900. The S&P 500 was down 42 points, or 1%, near 4,028, at last check on Monday.

It is a key week for the stock market. This global strategist warns that if you are not nervous, you should be.

Wilson argued that investors seem to have forgotten the cardinal rule of Don t Fight the Fed. He said the upcoming FOMC meeting, which ends on Wednesday, will serve as a reminder.

The central bank is expected to raise its target federal-funds rate by 25 basis points to a range of 4.5% to 4.75%. According to the FedWatch tool, traders now place a 98% probability of that size hike.

The Fed has yet to signal a willingness to hit the brakes and to pivot to a more dovish stance. In our view, Wilson believes that the worst earnings recession since 2008 is being mispriced once again.

The stock market and the Fed are on a collision course this week. Morgan Stanley's 2023 base case forecast for S&P 500 earnings per share EPS is $195, while their bear case forecast is $180. EPS is the number of shares outstanding divided by net income, and could indicate how much money a company makes for each share of stock.

Wilson and his team said they are now leaning more toward their bear case of $180 based on margin degradation. We think it is important to note that the Fed is cutting rates when earnings growth goes negative. That is not the case this time around, which is an additional headwind for equities.