The recovery in 2024 and 2025 looks promising, but the worst of the earnings cycle is likely not over, even for technology stocks.
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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 Monday, June 5th at 11 a.m. in New York. So let's get after it.
For the past several years, our overarching view on markets has been driven by our hotter but shorter cycle regime framework. More specifically, we wrote a report over two years ago that argued this cycle will run hotter, but shorter than what we've experienced over the past 50 years. We based this thesis in part on our comparison to the post-World War II time period, which looks quite similar to today in many respects. First and foremost, the excess savings buildup during World War II and the COVID lockdowns were released into the economy at a time when supply was constrained. The punch line is that both the fundamentals and asset prices returned to prior cycle highs at a historically fast pace. There's booming inflation in earnings in 2021, then led to the Fed tightening policy at the fastest pace in 40 years, a policy reaction that proved to be surprising to many investors. Now, we suspect many will be surprised again by the depth of their earnings decline in 2023, as well as the subsequent rebound in 2024 and ‘25.
In a major deviation from the past 30 years, we think stocks are now positively correlated to the rate of change and inflation. We also believe this new inflationary cycle is better for stocks and bonds, at least over the secular time horizon of 7 to 10 years. However it will be volatile, with significant cyclical ups and downs that should be traded if one wants to fully capture the excess returns in this new regime. In short, the boom bust period that began in 2020 is currently in the bust part of the earnings cycle, a dynamic that has yet to be priced during the bear market that began 18 months ago.
There are two key assumptions we think are now being made by many investors that may be erroneous. First, the worst of the interest rate hikes are now behind us. And second, technology stocks already experienced the worst of the earnings recession last year and can now look forward to accelerating growth in the second half of 2023. In fact, that reacceleration in earnings growth is now built into consensus expectations. Suffice it to say, we respectfully disagree with that conclusion. More importantly, this is a big change from the beginning of the year when our earnings outlook was not out of consensus. We think this has to do with companies sounding more optimistic about the second half, combined with the newfound excitement around artificial intelligence, or A.I., and what that means for both growth and productivity. While there will undoubtedly be individual stocks that deliver accelerating growth from spending on A.I. this year, we do not think it will be enough to change the trajectory of the overall cyclical earnings trend in a meaningful way. Instead, it may pressure margins further, as companies decide to invest in A.I. despite decelerating growth in the near term.
