Since the Federal Reserve began raising interest rates in March 2022 to combat inflation, economists and Wall Street strategists have debated whether a recession would hit the United States and send stocks lower.
Mike Wilson, chief investment officer and chief U.S. equity strategist at Morgan Stanley, has been on the short side of the debate. In 2022, he correctly forecast Rising interest rates and high inflation will drive down stock prices. But to Wilson’s surprise, despite the threat of rising interest rates, inflation and even regional banking crises, the S&P 500 is up 19% this year, thanks in large part to the resilience of the labor market.
Recently, however, that rally has been tested, with the blue-chip index down 6% since the end of July. To Wilson, this is a sign that markets are in “purgatory” as they await the outcome of the Fed’s aggressive rate hikes.
“The market is trying to figure out – hard landing (or) reacceleration?” Senior Strategist Tell Bloomberg this week. “This hellscape is where we’re going to tilt back and forth, and the market is going to be sucked into lifeboats.”
Wilson explained that in a “late-cycle environment” like the one we have now, when a period of sustained rate hikes by the Fed is coming to an end, there is usually a lot of uncertainty, leading investors to take a cautious approach. But many investors may have become overly optimistic at the start of the year, as so many calls for a recession in 2022 proved premature.
“People wrongly called for a recession in the first half of the year, but that didn’t happen. Now they may wrongly believe that this nice soft landing will accelerate next year,” he said, arguing that investors were “overvalued” over the summer There is talk of a soft landing, where inflation is subdued without the need for a jobs-causing recession. .
Wilson worries we may exit the current market purgatory and enter a recession as low- and middle-income consumers have depleted the excess savings they accumulated during the pandemic and student loan repayments are restarting. That could lead to a slowdown in spending, which accounts for 70% of U.S. GDP.
“That’s the risk in the fourth quarter, can consumers continue to surprise on the upside?” he said.
The Wall Street veteran noted in Morgan Stanley’s “Market Thoughts” podcast Stock market valuations remained elevated on Monday amid threats to consumer spending, rising interest rates and the recent rise in oil prices. The S&P 500’s price-to-earnings ratio is 18 times, compared with its historical average price-to-earnings ratio of about 15 times.
Wilson’s base case forecast is that the blue-chip index will fall about 10% by the end of the year, to about 3,900 points. He said this means investors should remain defensive and avoid buying high-growth stocks again for the time being.
Seeking quality and profit
Given Wilson’s bearish bias, you might think he would recommend holding cash to avoid a base case scenario in which stocks drop 10%. But he said this week that simply hiding cash wasn’t the best approach. Instead, investors should look for high-quality large-cap stocks—companies with strong balance sheets and earnings, so they don’t have to borrow money to keep their businesses afloat amid high interest rates.
In a note Wednesday, Wilson and his team of analysts noted that high-quality stocks that offer dividends, especially growing dividends, may be investors’ best bet during uncertain times. They found that dividend-paying stocks historically outperformed non-dividend-paying stocks, especially when inflation rose but fell.
“Today’s macro environment generally favors outperformance by dividend payers,” they explain. “Dividends provide a positive return cushion, with payers and non-payers significantly outperforming non-payers during periods of market volatility.”
Wilson and his team recommend using a “holistic” approach to selecting dividend stocks, focusing on a company’s valuation relative to its peers, historical volatility during difficult times, and overall leverage (think: debt).
They offer the best dividend picks with a three- to five-year outlook, including Verizon Communications, real estate investment trust (REIT) Realty Income, energy giant Exxon Mobil and more (shown in the chart below).
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