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Morgan Stanley Sees More Fed Hikes While JPMorgan Expects Pivot

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(Bloomberg) -- Top Wall Street strategists disagree over the impact of weaker economic data on the Federal Reserve’s policy outlook and what it’ll mean for stocks.

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While Morgan Stanley strategists say it’s too early to expect the Fed to stop tightening its policy even as fears of a recession grow -- suggesting stocks have more room to fall before finding a bottom, JPMorgan Chase & Co. strategists say bets that inflation has peaked will lead to a Fed pivot and improve the picture for equities in the second half.

Sticky inflation is what will keep the Fed hawkish for longer this time around, according to Morgan Stanley’s Michael J. Wilson. While during the past four cycles the US central bank had stopped tightening its policy before the start of an economic contraction, triggering a bullish signal for stocks, current historic levels of inflation mean the Fed will likely still be tightening when a recession arrives, Wilson wrote in a note.

Equity markets “may be trying to get ahead of the eventual pause by the Fed that is always a bullish signal,” Wilson said. “The problem this time is that the pause is likely to come too late.”

Over at JPMorgan, Mislav Matejka said in a note on Monday that challenging activity momentum and softer labor markets could open doors to a more balanced Fed policy, leading to a peak in the US dollar and inflation.

The S&P 500 Index has attempted to rebound this month and is set for the best gain since October after a sharp slump in the first half of the year, as corporate earnings have been better than feared and a lot of bad news gets priced in. Investors are now laser focused on the Fed’s meeting this week, where the central bank is expected to raise rates by another 75 basis points following its biggest increase since 1994 last month.

Paolo Zanghieri, senior economist at Generali Investments, said he expects the pace of rate hikes to slow after this week’s meeting.

Still, concerns are growing that the Fed could already be too late in its attempt to tame inflation and avoid a US recession. More than 60% of the 1,343 respondents in the latest MLIV Pulse survey said there’s a low or zero probability of the central bank reining in consumer-price pressures without causing an economic contraction.

READ: Bonds’ Rough Ride Nears End as Fed Risks Recession: MLIV Pulse

Jefferies LLC strategist Sean Darby said that while the economic slowdown is building, he expects the pressure on stocks from tighter monetary policy to ease in the second half of this year.

“Unlike the words ‘recession’ and ‘hyperinflation’ which have garnered a lot of news headlines, ‘pivot’ has yet to capture the same interest,” he wrote in a note. “Nevertheless, if the shapes of the US yield curve and Fed futures curves are correct, then the headwind from rate hikes will decelerate somewhat as tightening enters the last part of the year.”

Wilson, who has been among the most vocal bears on US stocks and correctly predicted this year’s selloff, said that even though inflation could indeed have peaked “from a rate of change standpoint,” the impact on consumer demand won’t “easily disappear even if inflation declines sharply because prices are already out of reach in areas of the economy that are critical for the cycle to extend.”

A rising number of analysts have also said that with inflation proving persistent at a four-decade high, it will take a recession -- and markedly higher joblessness -- to ease price pressures significantly.

JPMorgan’s Matejka said that another factor that improves the outlook for equities in the second half of the year is the changing reaction to earnings, where weaker results can start being seen as good news.

Wilson disagrees, saying that earnings estimates for S&P 500 firms are still too high and that the second quarter is likely to be the first of “several disappointing quarters before estimates finally trough.”

As such, stocks may have further to fall before hitting a bottom, he said. “Recent positive price action to some earnings cuts is unlikely to be the low for most stocks as it’s usually unwise to buy the first cuts when we are entering a major revision cycle,” Wilson wrote on Monday.

Strategist David J. Kostin at Goldman Sachs Group Inc. also sees pressure on S&P 500 revenues from a stronger dollar. The bank’s top-down model shows that a 10% appreciation in the trade-weighted greenback should reduce earnings-per-share by 2% to 3%, he wrote in a note on July 22.

(Adds comment from Generali Investments and Jefferies from seventh paragraph)

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