Rapidly declining inflation poses a challenge to revenue growth and earnings. So what should investors look out for to identify the winners from here?

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, July 25th at 10 a.m. in New York. So let's get after it.

As discussed in last week's podcast, this year's equity market has been all about expanding valuations. The primary drivers of this multiple expansion have been falling inflation and cost cutting rather than accelerating top line growth. Last October, we based our tactically bullish call on the view that inflation was peaking, along with back end interest rates and the US dollar. While the 30% move in equity multiples on the back of this theme has gone much further and persisted longer than we anticipated, we don't feel the urge to turn bullish now. Missing the upside this year was unfortunate, however, compounding with another bad call can lead to permanent loss.

While falling inflation supports the expectations for a Fed pivot on monetary policy, it also poses a risk to nominal revenue growth and earnings. To remind listeners of a key component to our earnings thesis, we believe inflation is now falling even faster than the consensus expects, especially the inflation experienced by companies. With price being the main factor keeping sales growth above zero for many companies this year, it would be a material headwind if that pricing were to roll over. This is precisely what we think is starting to happen for many businesses, especially in the goods portion of the economy.

Last year's earnings disappointment in communication services, consumer discretionary and technology were significant, but largely a function of over-investment and elevated cost structures rather than disappointing sales. In fact, our operational efficiency thesis that worked so well last year was adopted by many of these companies in the fourth quarter, and they've been rewarded for it. From here, though, we think sales estimates will likely have to rise for these stocks to continue to power higher, and this will be the key theme to watch when they report. Last week was not a good start in that regard, as several large cap winners disappointed on earnings and these stocks sold off 10%.

The same thing can be said for the rest of the market, too. If we're right about pricing fading amid falling inflation, then sales will likely disappoint from here. We think it's also worth keeping in mind that the economic data is not always reflective of what companies see in their businesses from a pricing standpoint. Recall in 2020 and 21, the companies were extracting far more than CPI-type pricing as demand surged higher from the fiscal stimulus, just as supply was constrained. This was the inflation driven boom we pointed to at the time, a thesis we are now simply using in reverse.

Bottom line, investors may need to focus more on top line growth acceleration to identify the winners from here. This will be harder to find if our thesis on inflation is correct and cost cutting and better than feared earnings results would no longer get it done, at least in the growth sectors. On the other side of the ledger, we have value stocks where expectations are quite low. Last week, financial stocks outperformed on earnings results that were far from impressive, but not as bad as feared. That trade is likely behind us, but with China now offering some additional fiscal stimulus in the near term, energy and materials stocks may be poised for a catch up move using that same philosophy. In short, growth stocks require top line acceleration at this point to continue their run, while value stocks can do better if things just don't deteriorate further.

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

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