Labor Data Expected to Be Major Driver of Equity Markets in Next 3-6 Months: Morgan Stanley

Investing Insights: Analyzing Market Dynamics Post-Fed Meeting

Before the recent Federal Reserve meeting, Morgan Stanley expressed optimism regarding equity markets, suggesting that a 50 basis point rate cut by the Fed could create a favorable short-term scenario, provided it didn’t raise concerns about economic growth.

In a note released on Sunday, Morgan Stanley strategists acknowledged that Fed Chair Jerome Powell successfully maintained this balance, leading to a positive response in equity markets.

However, the strategists emphasized that in the coming 3-6 months, the performance of equities—across indices and sectors—is expected to be largely influenced by labor data rather than other factors. With the next employment data set to be released at the end of the week, they believe that a positive surprise in this data will be critical for encouraging a sustainable shift in the U.S. market.

Specifically, they noted the necessity for the unemployment rate to decline while payroll gains exceed expectations, without substantial down revisions in previous months.

In addition to labor data, the strategists are closely monitoring several other indicators to evaluate the growth trajectory. One of these is earnings revisions breadth, regarded as a reliable measure of company guidance. Although the overall S&P 500 remains stable, the Russell 2000 small-cap index and other lower-quality sectors are showing negative trends. Upcoming seasonal factors may pose additional challenges for earnings revisions breadth in the near term.

Another area of focus is the ISM Manufacturing PMI, which has not shown signs of recovery after over two years of stagnation, although the ISM Services index has exhibited more resilience. Furthermore, both the Conference Board’s Leading Economic Indicator and Employment Trends Index are currently in defined downtrends.

These indicators are typical of a later-stage economic cycle and suggest that investors should prioritize higher quality and larger-cap assets, even in light of recent policy stimulus announcements from China.

While China’s stimulus measures are not anticipated to significantly impact U.S. growth or labor dynamics, it is expected that Materials and Industrials stocks may experience short-term benefits.

Additionally, the August budget deficit was noted to have surpassed forecasts by nearly $90 billion, raising concerns about fiscal sustainability as the debt-to-GDP ratio hits record highs. This deficit-driven fiscal stimulus has supported growth but has also crowded out sections of the private economy, contributing to a K-shaped recovery.

Inflation remains a key concern, as any decline below target levels could spark questions regarding the long-term viability of such deficits.

In this context, gold has outperformed most assets, including the S&P 500, while high-quality real estate and inflation hedges have also shown strong performance. Cryptocurrencies have surfaced as another hedge, although they are characterized by high volatility.

Conversely, lower-quality assets such as small-cap stocks, commodities, and unprofitable growth companies have underperformed, diminishing in value in real terms.

To alter these trends, there must either be a resurgence in private sector growth favoring cyclical assets or a recession that resets prices, potentially paving the way for an early-cycle recovery.

Without either scenario, market conditions are likely to remain stagnant, with a soft landing being the base case.

In summary, the Fed’s larger-than-expected rate reduction may provide short-term stabilization for lower-quality cyclical stocks, particularly following China’s recent stimulus actions. However, for these trends to persist through the end of the year, improvements in labor data and other growth indicators will be essential to support a soft landing characterized by reaccelerating growth, stabilizing inflation, and ongoing rate cuts by the Fed.