S&P 500 could move downward from its current levels in the next year and hit a target of 4,400, said Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. In their 2022 US equity outlook, analysts at Morgan Stanley have narrowed down three potential outcomes for Wall Street in the coming year. Of these, their base case, with a 60% probability of happening, expects inflation to remain hot and an aggressive response from the US Federal Reserve. Currently, the S&P 500 sits at 4,620 after having gained close to 25% year-to-date.
Base case sees S&P 500 at 4,400
In their base case scenario, inflation proves to be stickier as supply chains and labor shortage remain difficult to fix in the short term, resulting in the US Fed tapering faster and even raise rates on a more aggressive path. “At the same time, operating leverage fades as costs increase more in line with revenues. This leaves market breadth narrow in the near-term as valuations fully normalize in line with the typical mid-cycle transition,” Mike Wilson said. Wilson added that while there is some debate around how much P/Es need to fall, analysts at Morgan Stanley believe 18x is the right number to use for year-end 2022. “When combined with 10% earnings growth, that gives us a slight downside to the index from current prices, or 4,400 on the S&P 500. We put a 60% probability on this outcome,” he said.
Bull and bear case
Under the bull case scenario, Mike Wilson said that they expect supply to pick up from the first quarter to meet the excess demand, while inflation has a fast and soft landing near 2-3% range. This, in Morgan Stanley’s view, allows for growth to remain strong and multiples to remain high. In the bull case scenario, the S&P 500 is expected to reach 5,000 by year-end 2022. On the other hand, the bear case scenario assumes supply ticks up, but demand fades away. “Under this scenario, the Fed may back off on their more aggressive tightening path. Rates fall, but not enough to offset the negative impact on margins and earnings, which will end up disappointing,” they added.
How to trade?
With the probability of the base case increasing with the inflation numbers remaining hot, earnings are expected to remain strong. “In this kind of an environment, we continue to favour companies with earnings stability and reasonable valuations. That means large-cap defensive quality stocks. In short, boring can be beautiful,” Mike Wilson said.