Wall Street Fears What Higher Rates Will Do to Corporate America

(Bloomberg) — Some of Wall Street’s biggest banks expect a lengthy period of higher interest rates to further pressure Corporate America’s profit engine, threatening equity gains as companies grapple with elevated financing costs and margin-shredding inflation.

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While corporate earnings have been better than feared this season, Morgan Stanley and Bank of America Corp. strategists have warned that profit estimates will need to be cut much further before stocks can find a true low.

Now, strategists at Bank of America expect the Federal Reserve to raise rates by a half percentage point in September. A strong employment report for August, due this Friday, could even tip the balance in favor of a 75 basis point hike, they said.

“If achieving the dual mandate in pre-pandemic times required a ‘lower for longer’ policy rate, we expected the main message coming out of Jackson Hole to be that conditions now required ‘higher for longer’ policy rates,” Bank of America strategists wrote in a note. “The message from Jackson Hole met our expectations.”

In a speech at the symposium Friday, Fed Chair Jerome Powell signaled that the central bank will keep tightening policy, even if it hampers growth, saying that a restrictive stance was likely to remain in place “for some time.”

The equity market tumbled after Powell’s speech as it “became a victim of its own momentum over the past few months,” Morgan Stanley strategists led by Michael J. Wilson wrote in a research note Monday, adding that valuations are still above fair value even after they pulled back. Losses spilled over into Monday, with the S&P 500 Index shedding nearly 1%.

“Friday’s action could be the beginning of what is likely to be an elongated adjustment period to growth expectations,” the Morgan Stanley strategists said. At a minimum, there’s 5% downside to earnings expectations, but that downside could be as significant as 15%-20%, they wrote.

While many companies are susceptible to rising rates, technology companies are particularly at risk because many of them are valued on projected profits delivered years in the future. The present value of those future profits are worth less as yields rise. Soaring interest rates also make financing operations more expensive, increasing hazards for younger companies that are burning cash in pursuit of rapid growth.

Wilson, one the most vocal and staunch bears on US stocks, has consistently warned that the recent equity rally will be temporary due to risks posed by the economy, tighter monetary policy and the outlook for corporate profits. On Monday, he said that weaker earnings pose the largest threat to US stock prices.

“The path for stocks from here will be determined by earnings, where we still see material downside,” the Morgan Stanley strategists wrote. “As a result, equity investors should be laser focused on this risk, not the Fed.”

The Morgan Stanley strategists are watching a couple of gauges that indicate pressure on profit margins and risk to earnings growth: the spread between forward sales growth and the rate of change on the producer price index, as well as the spread between nominal gross domestic product growth and wage growth. Their leading earnings model, which projects a steep fall in earnings per share growth over the next several months, also confirms that view, they said.

Meanwhile, JPMorgan Chase & Co.’s Marko Kolanovic, one of Wall Street’s staunchest bulls, has defended his 2022 calls for dip buying, while warning that the Fed would risk disrupting financial markets by going too hawkish right before US midterm elections. His team is sticking to the year-end target of 4,800, a 18% gain from Friday’s close.

(Updates from first paragraph with BofA research note.)

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