August Jobs Report to Evaluate Market Recovery, According to Morgan Stanley

Analysts at Morgan Stanley attribute the sharp correction in stocks during July and early August to a variety of factors, primarily focusing on disappointing economic growth data, which culminated in a weak employment report released on August 2.

The upcoming August jobs report, set for release on September 6, is anticipated to be decisive for the market’s ability to maintain its recent rebound or if it will face renewed concerns over economic growth, exerting further downward pressure on stock valuations. Morgan Stanley predicts that this crucial report will substantially influence market trajectory.

The summer market downturn was largely triggered by a series of unsatisfactory economic indicators, including an increase in the unemployment rate by 0.2 percentage points, which activated a prominent recession indicator—the Sahm Rule—heightening fears of a potential hard landing for the economy. This situation prompted a widespread sell-off in equities.

Although some encouraging economic data has emerged since then, such as better-than-expected jobless claims, retail sales, and non-manufacturing survey results, the recovery in equity markets has been uneven. Many indices are approaching all-time highs, yet indicators from the bond market, the yen, and commodities reveal persistent caution among investors. Additionally, the performance disparity between cyclical and defensive stocks suggests a cautious market sentiment.

Morgan Stanley analysts emphasize that the upcoming jobs report will serve as a critical benchmark for the market’s recovery. A stronger-than-expected payroll increase and a reduction in the unemployment rate could bolster market confidence, suggesting that growth risks have diminished and allowing equity valuations to stabilize. Conversely, a lackluster jobs report that indicates a higher unemployment rate may reignite fears of a hard landing and exert renewed pressure on equity valuations.

The economists at Morgan Stanley project a non-farm payroll increase of 185,000 jobs and a drop in the unemployment rate to 4.2%, aligning with market expectations. However, they note the significant implications given the current valuation levels of the market.

Morgan Stanley points to the challenges faced by equity investors, with the market trading at 21 times earnings—placing it in the upper decile of its historical valuation range. This valuation is based on consensus earnings per share (EPS) growth estimates of 11% for this year and 15% for the next, both above the long-term average of 7%. Given these elevated valuations and optimistic earnings expectations, the firm anticipates limited upside for index levels over the next 6-12 months, especially if the economy follows a soft-landing scenario, which is their primary case.

Current market valuations indicate vulnerability to a downturn in the event of a hard landing. The forthcoming labor report is pivotal, as it may either affirm or undermine current market sentiment.

Additionally, Morgan Stanley observes that the Bloomberg Economic Surprise Index, which measures the deviation of economic data from expectations, has not yet reversed its downward trend that began in April. Furthermore, cyclical stocks continue to underperform compared to defensive stocks, implying that growth concerns are still prevalent.

Unlike past corrections in 2022 and early 2023, which were primarily driven by inflation risks, the present market dynamics center on growth uncertainties. This transition suggests that investors may want to hold more high-quality defensive stocks until there is clearer evidence of improving economic conditions.

Analysts recognize that AI stocks have been a significant driver in the U.S. market, but recent disappointing earnings have led to declines in many of these stocks. While Morgan Stanley does not believe the AI trend has come to an end, they suggest the possibility of investors seeking new themes capable of attracting substantial investment.

In light of this, analysts advise against moving into small-cap or undervalued cyclical stocks that have struggled in recent years. They argue that these sectors typically do not perform well during late-cycle environments with potential rate cuts by the Federal Reserve.

Morgan Stanley indicates that the bond market has already factored in some of the Fed’s anticipated interest rate reductions. With long-term rates falling significantly over the last ten months, borrowing has become cheaper for mortgages and other loans. However, sectors that are sensitive to interest rates, such as housing and automotive purchases, have not yet experienced a boost.

This lack of responsiveness from cyclical segments further supports a cautious outlook from the analysts. Unless the Federal Reserve cuts rates more than currently expected, the economy strengthens, or additional policy stimulus is enacted, Morgan Stanley anticipates minimal returns at the index level over the next 6-12 months.