Disinflation will shift to deflation, hitting earnings and sending stocks lower, Morgan Stanley CIO says

• Deflation could become a headwind for stocks, Morgan Stanley's Mike Wilson warned.
• That's because falling prices takes away firms' pricing power, which hurts earnings.
• "[T]his is a slippery slope for earnings growth and hence stock valuations, which are now quite extended," Wilson said.

Disinflation is about to turn into deflation – a major headwind for corporate earnings, and in turn stock prices, that investors have yet to take into account, according to Morgan Stanley's chief stock strategist Mike Wilson.

In a podcast on Monday, Wilson  pointed to easing consumer and producer prices, which have fueled investors' hopes for a soft-landing of the US economy. In June, consumer prices accelerated 3% year-over-year, down significantly from 9.1% last summer. Meanwhile, producer prices accelerated just 0.1% year-per-year, down from 0.9% in June 2022.

Markets have interpreted that as positive news for stocks, as cooler inflation in the economy could lead the Federal Reserve to soon pause rate hikes or even cut interest rates. 

But it takes around 12 months for the full effect of rate hikes to surface in the real economy, Wilson said. That could mean inflation will cool much faster than expected, to the point where prices actually begin falling. The result could end up being not just disinflation—where prices rise at a slower pace—but outright deflation, wherein prices decline. 

That would be bad news for stocks, as companies saw an earnings boost throughout the last year of high inflation as they were able to pass on higher costs to their customers. 

Deflation, meanwhile, takes away companies' pricing power and is likely to hurt future earnings. 

"We think inflation is likely to surprise on the downside," Wilson said. "A move to disinflation is positive for stocks, because valuations typically rise under those circumstances. However, that has already happened. Now, we expect disinflation to shift to deflation in many parts of the economy."

Signs of deflation are already beginning to bubble to the surface. Housing prices and car prices have been on the decline, and even areas like airlines and hotels, which have been propped up by strong demand, have seen prices fall – a sign pricing power is already beginning to fade.

"While falling inflation was great news for the Fed and its war on higher prices, equity investors should be careful for what they wish for, because this is a slippery slope for earnings growth and hence stock valuations, which are now quite extended," Wilson said.

Wilson has been bearish on stocks for months, and previously sounded the alarm for one of the worst earnings recessions since 2008 to hit stocks. That could lead corporate earnings to slump 16%, strategists at the bank previously warned.