S&P 500: Higher interest rates and peaking earnings revisions to be difficult to handle – Morgan Stanley

US equities markets have continued to perform well, fueled by upbeat earnings and vaccination news. However, that’s often when surprises arise. A correction would be welcome at this point, as sentiment and positioning have reached extreme levels, as Mike Wilson, Chief Investment Officer and Chief US Equity Strategist for Morgan Stanley notes.

Key quotes

“Fourth quarter earnings proved to be terrific for most companies. With 419 companies in the S&P 500 reporting so far, earnings per share have come in 18% higher than the consensus estimate. Sales have been just 3% higher on average, suggesting our operating leverage theme is really playing out. Fourth quarter sales actually grew 1% year over year. When combined with a lower unemployment cost and other operating expenses, profit margins have moved to near all-time highs. In short, the recession is over for corporate profits.”

“After a slow start, the vaccination process has picked up nicely. In addition, there is some evidence that the first shot of the vaccine could provide 75% effectiveness against symptoms of any kind. Meanwhile, new cases are falling more rapidly than expected, and several leading health experts are even saying we may achieve herd immunity as early as April.”

“At this point, it seems like nothing can slow this bull market. However, that's exactly when surprises usually arise. We see two potential risks to be thinking about as we exit February. First, is the risk associated with interest rates rising sharply as bond markets simply catch up to what other asset prices are already reflecting. Second is the risk that some of the positive operating leverage that we've been witnessing in company earnings reports starts to go in reverse.”

“With this macro backdrop, we continue to favor areas in the market that are reasonably priced or can benefit from rising rates and inflation. Areas like banks, materials and energy. We also favor reopening beneficiaries in the consumer and business services sectors, as markets begin to digest a faster return to normal activities.”