As we head into the end of the year, investors are again worrying about the impact that higher interest rates will have on growth.

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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 you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 30th at 10 a.m. in New York. So let's get after it.

2023 has been a year of big swings for stock investors. Coming into the year, the consensus agreed that domestic growth is going to disappoint as recession risk appeared much higher than normal. The primary culprit was the record setting pace of tightening from the Federal Reserve and other central banks in 2022. In addition to this concern, earnings for the mega-cap leaders had disappointed expectations during the second half of 2022. As a result, sentiment was low and expectations about a recovery were pessimistic. Stocks had reflected some of that pessimism, even though they had rallied about 10% from the October '22 lows.

The other distinguishing feature of the consensus view at the beginning of the year is that the bullish pitch was predicated on a Fed pivot and China's long awaited reopening from its lengthy pandemic lockdowns. This meant that many investors were overweight banks, industrials and commodity oriented stocks like energy and materials and longer duration bonds rather than mega-cap growth stocks. Such positioning could not have been worse for what has transpired this year. Domestic economic growth and interest rates have surprised on the upside, keeping the Fed more hawkish on its rate policy while commodity prices have been weak due to disappointing global economic growth despite China's reopening.

The regional bank failures in March spurred a different kind of pivot from the Fed, as they decided to reverse a good portion of its balance sheet reduction when it bailed out the uninsured deposits of these failing institutions. That liquidity injection spurred a big rally in companies with the highest quality balance sheets. Newfound excitement then around artificial intelligence provided another reason for mega-cap growth stocks to trade so well since the March lows. This summer, that rally tried to broaden out as investors began to think artificial intelligence may save us from the margin squeeze being felt across the economy, especially smaller cap companies that don't have the scale or access to capital to thrive in such a challenging environment to grow profits.

But now, even the higher quality mega-cap growth stocks are suffering. Since reporting second quarter earnings, these stocks are lower by 12% on average. Third quarter earnings were supposed to reverse these new down trends, but last week that didn't happen. Instead, most of these company stocks traded lower, even though several of them posted very strong earnings results. In our experience, this is a bearish signal for what the market thinks about the business and earnings trends going into 2024. In other words, the market is suggesting earnings expectations are too high next year, even for the best companies.

Our take is that given the significant weaknesses already apparent in the average company earnings and the average household finances, we think it will be very difficult for these mega-cap companies to avoid these headwinds too, given these small companies and households are their customers. Finally, with interest rates so much higher than almost anyone predicted six months ago, the market is starting to call into question the big valuations at which these large cap winners trade.

From our perspective, it appears that 2023 is coming full circle, with markets worrying again about the impact that higher interest rates will have on growth rather than just valuations. The delayed impact and reaction on the economy is normal, but once it starts, it's hard to reverse. While we were early and wrong in calling for this outcome in the spring, we think it's now upon us. For equity investors, what that really means is that this year is unlikely to see the typical fourth quarter rally.

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