Morgan Stanley lays out the stock market’s best-case scenario for this week’s Fed decision – and 2 areas to buy after the cut

• Ideally, the Fed will cut rates by half a point without triggering growth concerns, Morgan Stanley says.

• CIO Mike Wilson noted that the bond market is behaving as if the Fed is behind the curve.

• He said defensive and quality stocks are worth holding after Wednesday’s rate cut.

Wall Street is gearing up for a key interest rate cut announcement on Wednesday, and there is still uncertainty about how far the Federal Reserve will go.

As of Monday morning, CME’s FedWatch tool showed the market pricing in a 59 percent chance of a 50 basis point cut. According to new research from Morgan Stanley, that would be the best possible outcome for the stock. But there’s a caveat: they have to deduct half a point and it keeps the market from worrying about economic growth.

“In the very near term, we think the best-case scenario for stocks this week is that the Fed can deliver a 50bp rate cut without triggering growth concerns or any remnants of the yen leading to a trade-off — that is, purely simply an “insurance reduction”. “Ahead of macro data which is assumed to stabilize,” Chief Investment Officer Mike Wilson wrote in a note on Monday.

In the months leading up to this week’s Federal Reserve policy meeting, deteriorating labor force data convinced investors that the central bank must start cutting borrowing costs to prevent an economic cooling.

In Morgan Stanley’s view, the Fed may want to cut by 50 basis points as the bond market signals that monetary policy is behind the curve: if interest rates stay higher for too long, they risk breaking something in the economy .

At the same time, some analysts noted that aggressive tapering could be the Fed’s way of acknowledging problems in the economy.

Before the rate cut, Morgan Stanley suggested that investors increase exposure to two cohorts of stocks that have historically outperformed in similar environments: defensive and high-quality.

Part of the reason is due to growing growth concerns. Although the S&P 500 is signaling high confidence that the Fed will deliver a soft landing and 15% earnings per share growth through 2025, market internals are telling a different story: Investors are flocking to defensive stocks on fears of a slowdown.

Against this backdrop, the defensive performance against cyclicals was the strongest since the last recession, Wilson noted. Defensive stocks include sectors such as utilities and consumer staples — groups that are less dependent on macroeconomic conditions to perform well.

“Defensives tend to outperform cyclicals fairly consistently both before and after the discount. Large caps also tend to outperform small caps both before and after the Fed’s first rate cut. These last two factors support our defensive and large-cap bias as the Fed tapers. they often occur in a later cycle environment,” Morgan Stanley said.

Read the original article on Business Insider