Earlier in 2019, stocks rallied partly on expectations that the worldwide economy was hitting bottom and set to rebound later in the year. Among the more prominent skeptics has been Michael Wilson, chief U.S. equity strategist and chief investment officer (CIO) at Morgan Stanley. "We disagreed with that narrative, suggesting that the global economy would likely not bottom in 1Q," Wilson writes in the Sept. 1, 2019 edition of the Sunday Start report from Morgan Stanley.

"We argued that corporate profits would disappoint and therefore so would capital spending and eventually other corporate activity affecting the economy, including hiring and wage increases," Wilson continues. "Fast forward to today, and it’s safe to say that the global economy has disappointed most expectations this year, even ours," he adds.

Significance for Investors

Wilson elaborates further: "Since last October, I’ve been steadfast in my call for a U.S. profits recession this year and skeptical of the big second half recovery that company management teams promised back in the first quarter. With second quarter earnings season throwing cold water on a second half recovery in profits growth, S&P 500 3Q EPS expectations are now down to -2.7%, well below the -0.5% growth in the first half of the year."

"The bullish narrative today is that while the U.S. industrial/manufacturing part of the economy is weak, the U.S. consumer remains strong, so the U.S. economy can avoid a further slowdown or recession," Wilson says. Personal consumption expenditures (PCE) currently represent about 68% of U.S. GDP, per the Federal Reserve Bank of St. Louis. However, deteriorating corporate profits inevitably will restrain wage growth, which ultimately will slow the rate of increase in consumer spending. It could get even worse than that.

"A broad profits recession, if it doesn’t get better soon, is exactly what could lead to layoffs. Obviously, such an outcome would negatively affect the U.S. consumer and is really all that separates the U.S. economy from a recessionary outcome. On that score, we’re already seeing companies take action on labor by reducing the number of hours worked and hiring at a much slower pace than last year," Wilson warns.

Meanwhile, the Federal Reserve has sounded an optimistic note. "The labor market remains strong," per a statement from the FOMC released in June. "Job gains have been solid, on average, in recent months, and the unemployment rate has remained low," they added.

Looking Ahead

Wilson is not predicting that widespread layoffs are on the horizon, but he believes that "the risk is elevated." He expects that 3Q 2019 profits will continue to be weak, partly the result of new tariffs that took effect on Sept. 1, and that the S&P 500 will sink to a value of 2,700, or 7.1% below the close on Sept. 3.

Wilson advises investors to be overweight in defensive stocks such as utilities and consumer staples. "Be careful with expensive secular growth stocks that aren’t priced for a potentially weaker labor market and higher risk of recession," he adds.