Morgan Stanley Sees Rates Risk to Stocks. Bank of America Says Not So Much

(Bloomberg) -- A pair of Wall Street's most prominent US equity strategists are at odds about whether stocks can extend this year's rally against the reality that interest rates will remain higher for longer.

Morgan Stanley's Michael Wilson, an unwavering equity bear, says the correlation between real rates and equity returns has fallen deeper into negative territory — a sign that interest rates have once again become a determinant of stock performance. At Bank of America Corp., however, Savita Subramanian thinks equity markets can still thrive if rates remain elevated.

“Since mid-July, stocks have experienced a distinct change in personality,” Wilson wrote in a note to clients dated Oct. 1. He added that the leg lower in US equities following the latest Federal Reserve meeting last month suggests investors are “beginning to question the ‘higher for longer' narrative.”

Wilson, who correctly called 2022's stock market rout but failed to predict this year's rally, has been vindicated by weakness across US stocks since the summer. The S&P 500 Index logged back-to-back drops in August and September, paring some of its double-digit gain this year.

In contrast, BofA's Subramanian sees reasons to be bullish even if borrowing costs stay high. For starters, 50% more large-capitalization companies have dwindled into small caps than vice versa, a reversal from prior decades — and a sign that higher costs of capital have “purged weaklings,” with the attrition leaving the S&P 500 in “good shape.”

Moreover, she points out that the S&P 500 returned an annualized 15% per year between 1985 and 2005, while real rates were 3.5%.

Subramanian was among the first in a parade of sell-side strategists to turn positive on US stocks this year after missing a rally in the first half of 2023, raising her year-end S&P 500 forecast twice since May. She correctly predicted last year's stock plunge.

US equities extended their slide on Monday as bond yields pushed higher, further sapping the appetite for risk assets. The declines come after US stocks closed out their worst month of the year on Friday amid a weeks-long bout of selling over concerns about the toll of restrictive monetary policy on growth.

Although the turbulence has acquitted some equity bears after their gloomy calls failed to play out in the first half of the year, optimists have dismissed recent losses as a normal seasonal slump — pointing to discounted stocks and the upcoming earnings season as reason to buy, setting up for a potential year-end rally.

Goldman Sachs Group Inc. said Monday that the selloff has led to historically cheap valuations for technology stocks at a time when earnings estimates are still rising, a sign that shares can resume the blowout bullish run they staged earlier this year.

The glum mood as of late is another reason to buy stocks, according to BofA. Its sell-side indicator, a contrarian sentiment guage that tracks sell-side strategists' recommended equity allocations, stayed at a level in September that has historically preceded gains 95% of the time.

“Wall Street is bearish, conviction-less and stuck,” the bank said Monday. “Buy stocks, sell bonds.”

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