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Goldman and Morgan Stanley Say Stocks Don’t Fully Reflect Risks

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Wall Street is afraid to buy the dip this time around.

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(Bloomberg) — Wall Street is afraid to buy the dip this time around.

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Even amid this latest leg of the stock market selloff, equities still aren’t fully reflecting the risks facing corporate earnings, according to strategists at Morgan Stanley, Goldman Sachs Group Inc. and BlackRock Investment Institute. Weaker consumer demand and aggressive tightening by the Federal Reserve in an attempt to fight the hottest US inflation in four decades can do further damage to corporate bottom lines and, in turn, share prices.

“We’re not buying the stock dip because valuations haven’t really improved, there’s a risk of Fed overtightening, and profit margin pressures are mounting,” BlackRock strategists, led by Wei Li, wrote in a note to clients Monday.

Read: S&P 500 Margins Are Tanking and That Spells Trouble for Stocks

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That view echoes what’s being said by Morgan Stanley and Goldman Sachs, who both believe stocks aren’t fully reflecting the challenges facing the economy. BlackRock, which is overweight equities in the long run, is neutral on stocks over the next six to 12 months. While profit margins have climbed for the past two decades, BlackRock now see increasing risks as businesses struggle to pass on higher costs to consumers.

“We expect the energy crunch to hit growth and higher labor costs to eat into profits,” Li and her team added.

Depressed consumer sentiment is a key risk to the US stock market and economy as the Fed is set to keep fighting surging inflation with rate hikes, Morgan Stanley strategists led by Michael Wilson wrote in a note. Meanwhile, Goldman Sachs Group Inc. strategists led by David J. Kostin said that US earnings estimates are still too high and expect them to be revised downwards even further.

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Despite this year’s selloff in the S&P 500, “equity valuations remain far from depressed,” Kostin wrote in a note. The surprisingly high inflation data show “that the Fed’s battle with inflation has put a ceiling on equity valuations.” US inflation accelerated to a 40-year peak in May, while consumer sentiment plunged in early June to the lowest in data back to 1978. 

The S&P 500 is on the verge of entering a bear market after a four-session losing streak. At one point on Monday all 504 S&P stocks were in the red, something that hasn’t happened at the close since 2011. Investor are increasingly concerned that the latest inflation figures will push the Fed to extend an aggressive series of interest-rate hikes into the fall. The US central bank is due to announce its latest interest rate decision after its meeting ends on Wednesday.

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“The Equity Risk Premium does not reflect the risks to growth, which are increasing due to margin pressure and weaker demand as the consumer decides to hunker down,” Wilson wrote. “The drop in sentiment not only poses a risk to the economy and market from a demand standpoint, but it also, coupled with Friday’s CPI print, keeps the Fed on a hawkish path to fight inflation.”

Wilson has been among Wall Street’s most prominent bears and correctly predicted the latest market selloff. While Morgan Stanley strategists said that margin pressure and waning consumer demand dynamics have been priced in by the market, the risk of excess inventory is just now beginning to be reflected in stock prices. They reiterated their underweight on consumer discretionary shares. 

Wilson sees 3,400 points, or about 13% lower from Friday’s close, as a “more reliable level of support” for the S&P 500 by mid-to-late August if a recession is avoided, which accounts for earnings 3% to 5% lower than consensus, a 10-year Treasury yield at 3% and an equity risk premium at 370 basis points.

Goldman’s base case is that equity valuations will remain roughly flat, while earnings growth will boost the S&P 500 to 4,300 by year-end, or about 10% higher than current levels. 

(Updates with BlackRock’s outlook on equities)

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