- Morgan Stanley investment chief Michael Wilson says fading inflation will hurt corporate earnings.
- Wilson says that companies’ costs are starting to increase faster than their sales.
- He says that investors don’t realize how fast operating leverage is going to fall as that happens.
Michael Wilson’s argument is simple: ‘what goes up must come down.’
The chief US equity strategist and chief investment officer for Morgan Stanley says that truism applies to company earnings — specifically to operating leverage, or the ability of a company to turn revenue into profits.
In a note to clients published August 8, Wilson says that high inflation has bolstered US corporate profits this year, but as inflation begins to fade, profits will take a hit.
“Just like most underestimated the positive effects of inflation on operating leverage, we think they are underestimating the negative effects from inflation falling,” he wrote. “We see falling inflation weighing on profits as operating leverage starts to reverse.”
While second-quarter corporate earnings looked okay, Wilson writes that for most sectors, operating leverage fell — meaning that profits didn’t grow as much as sales did. That’s because wages and many expenses remain high and demand is either slowing or not increasing as quickly as those costs are.
To Wilson, most of Wall Street hasn’t caught up with that trend.
“Despite signs of margin compression this quarter amid this operating leverage dynamic, bottoms up consensus is still calling for margin expansion into 2023, a development that we find unrealistic due to sticky cost pressures (particularly in labor) and receding demand,” he wrote.
He explains that major corporate expenses tend to rise gradually, so they’ll keep increasing for some time even though demand has already peaked. That will create a “mirror image” of the jumping prices/slowly-rising costs dynamic of the last two years.
“Falling inflation will essentially have the exact opposite effect on profits that rising inflation did in 2020-21,” he wrote. “While prices to the end consumer are still rising at a rapid clip, prices for producers are rising at double the pace.”
With that in mind, below is Morgan Stanley’s “Fresh Money Buy List,” a group of the firm’s most-recommended stocks that has collectively outperformed the stock market. Morgan Stanley introduced the mini-portfolio in 2018 and updates it periodically.
The stocks on the buy list below are ranked based on the amount of upside they offer relative to Morgan Stanley’s price targets. Those percentages were calculated based on Thursday’s closing prices.