August jobs report to test market recovery, says Morgan Stanley By Investing.com

Investing.com — “Stocks’ sharp correction in July/early August was due to several factors, most notably weaker-than-expected economic growth data that culminated in a weak employment report on 2 August,” analysts said. at Morgan Stanley in a note.

The next release of the August jobs report on September 6 is expected to play a vital role in determining whether the recent market rally can continue or whether renewed concerns about economic growth will put further downward pressure on valuations actions.

Morgan Stanley analysts predict that this report will significantly influence the future trajectory of the market.

The market’s decline earlier this summer was mainly triggered by a series of disappointing economic indicators, culminating in a weak employment report on August 2.

The most important factor was a 0.2 percentage point rise in the unemployment rate, which activated the Sahm Rule – a key indicator of recession – and heightened fears of a potential hard landing for the economy. This spooked investors, leading to a broad sell-off in stocks.

While some positive economic data, including better-than-expected jobless claims, retail sales and the ISM non-manufacturing survey, have since emerged, the recovery in equity markets has been uneven.

Many indexes are back near all-time highs, yet the bond market, yen and commodities suggest lingering investor caution. Additionally, the “internals” of the equity market, such as the performance of cyclical stocks versus defensive stocks, have not recovered significantly, indicating cautious market sentiment.

Morgan Stanley analysts say the August jobs report will be a critical test of the market’s recovery. “A stronger-than-expected payrolls number and a lower unemployment rate would likely give markets more confidence that upside risks have abated, paving the way for equity valuations to remain elevated and a potential recovery in other lagging markets/stocks. ”, the analysts said.

Conversely, another weak jobs report, especially if it shows a further rise in the unemployment rate, could rekindle fears of a hard landing and put pressure on stock valuations again.

Morgan Stanley economists forecast nonfarm payrolls to rise by 185,000 jobs and the unemployment rate to fall to 4.2 percent, which is in line with market consensus. However, they caution that the stakes are high given current market valuation levels.

Morgan Stanley signals the challenge for equity investors in the current environment. It trades at 21 times earnings, which puts it in the upper decile of its historical valuation range. This is based on consensus estimates for earnings per share (EPS) growth of 11% this year and 15% next year — well above the long-term average of 7%.

Given these high valuations and high earnings expectations, Morgan Stanley sees limited upside to the index over the next 6-12 months, especially in a soft landing scenario, which is their base case.

The market’s current valuation levels make it vulnerable to a downside in the event of a hard landing. The upcoming employment report is crucial as it could either strengthen or weaken current market sentiment.

Morgan Stanley also notes that the Bloomberg Economic Surprise Index, which tracks the extent to which economic data beats or falls short of expectations, has yet to reverse its downward trend that began in April.

Additionally, cyclical stocks continue to underperform relative to defensive stocks, further suggesting that growth concerns remain prevalent.

Unlike the previous corrections in 2022 and early 2023, where inflation was the main risk, the current market dynamics are driven by growth concerns.

This shift supports the idea that until there is clearer evidence of improving economic growth, investors should favor high-quality defensive stocks in their portfolios.

Analysts believe AI stocks have been a major force in the U.S. market, but recent disappointing earnings have sent many of those stocks lower.

While Morgan Stanley doesn’t think the AI ​​trend is over, they suggest investors may be looking for a new market theme that can attract a lot of investment.

In this context, analysts advise against rotating into small-cap stocks or other cheap cyclical stocks that have underperformed in recent years. They argue that in a late-cycle, soft-landing scenario where the Federal Reserve cuts rates, these areas of the market typically underperform.

Morgan Stanley signals that the bond market was already expecting some of the Federal Reserve’s potential interest rate cuts. With back-end rates falling by more than 100bps in the last 10 months, borrowing is cheaper for things like mortgages. Despite this, highly interest rate-sensitive sectors such as housing, car purchases and credit card spending have yet to see a boost.

This lack of response from cyclical parts of the equity market further supports analysts’ cautious outlook. Unless the Fed cuts rates more than the market currently expects, the economy strengthens or additional policy stimulus is introduced, Morgan Stanley expects marginal returns on the index over the next 6-12 months.